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TRADING TECHNOLOGIES: DEFINING TOMORROW’S WORLD

ISSUE 75 • FEBRUARY/MARCH 2014

Committed ed to to Success: Success:

FTSE GLOBAL MARKETS

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IT’S DATA, BUT NOT AS WE KNOW IT US SEC LENDING: THE SEARCH FOR LIQUIDITY MIFID II: THE RIGHT KIND OF MARKET TRANSPARENCY?

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ISSUE SEVENTY FIVE • FEBRUARY/MARCH 2014

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OUTLOOK EDITORIAL Francesca Carnevale, Editor T: +44 207680 5152; E: francesca@berlinguer.com Andrew Neil, New media manager T: +44 207680 5157; E: Andrew.neil@berlinguer.com David Simons, US Editor, T: +1 E: DavidtSimons@gmail.com CORRESPONDENTS Lynn Strongin Dodds (Editor at Large); Ruth Hughes Liley (Trading Editor); Vanja Dragomanovich (Commodities); Neil O’Hara (US Securities Services); Mark Faithfull (Real Estate). PRODUCTION Andrew Lawson, Head of Production T: +44 207 680 5161; E: Andrew.Lawson@berlinguer.com Lee Dove, Production Manager T: 01206 795546; E: studio@alphaprint.co.uk RESEARCH Fahad Ali, Head of Research T: +44 207 680 5164; E: Fahad.Ali@berlinguer.com OPERATIONS Christopher Maityard, Publishing Director T: +44 207 680 5162; E: Chris.maityard@berlinguer.com Tessa Lewis, Finance Manager T: + 44 207 680 5159; E: Tessa.lewis@berlinguer.com CLIENT SOLUTIONS Patrick Walker, Global Head Of Sales T: +44 207 680 5158; E: Patrick.walker@berlinguer.com Sharron Lister, Client Solutions T: +44 207 680 5153; E: Sharron.Lister@berlinguer.com Veena Mistry, Client Solutions T:+44 207 680 5156; E: Veena.Mistry@berlinguer.com Nicole Taylor, Special Projects T: 44 207 680 2151; E: Nicole.taylor@berlinguer.com Marshall Leddy, North America Sales Director T: +1 612 234 7436, E: marshall@leddyassociates.com Adam Benchehou, Delegate Sales, T: + 44 207 680 5163 Billal Alakhal, Delegate Sales, T: + 44 207 680 5151 OVERSEAS REPRESENTATION Can Sonmez (Istanbul, Turkey) FTSE EDITORIAL BOARD Mark Makepeace (CEO); Donald Keith; Chris Woods; Jonathan Cooper; Jessie Pak; Jonathan Horton PUBLISHED BY Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD TO SECURE YOUR OWN SUBSCRIPTION Please enrol on www.ftseglobalmarkets.com Single subscription: £87.00 which includes online access, print subscription and weekly e-alert A premium content site will be available from September 2014 FTSE Global Markets is published 10 times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright Berlinguer Ltd 2014. All rights reserved). FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

ISSN: 1742-6650 Journalistic code set by the Munich Declaration. Total average circulation per issue, July 2011 - June 2012: 20,525

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

HE SECOND DECADE of this century was never going to be easy. Looking back through history, the second decade of a century is all about the loosening of ties with the previous century. Unfortunately, the description of the new is often punctured by last hurrahs from groups or leaders still anxious to hang on to ideas and notions that are long past their sell by date. Right now, it is hard cheese for the global investment markets, which remain fragile. Regulation continues to shake existing pillars and erect new supports; the ebb and flow of politics continues to batter market confidence; and investors try to shake off the last sticky vestiges of the recent financial crisis. How well we all do in managing to steer a comfortable and profitable path through this mangle of trends will be fascinating to watch and comment on. It looked at the end of December last year that all things being equal 2014 would bring new hope to markets and marketeers that had endured seven very lean years. The reality is that this year will run pretty much like 2013. That’s not bad news; but it is not great either. If it is not the mounting burden of compliance that challenges growth; it is those pesky macro-economic developments (Ukraine, Syria, dysfunction in Washington, continued market volatility; boom and bust economics in the emerging markets) that continue to undermine the efforts to wrestle in a bright new dawn. Bright spots are there as well, including strengthening home prices, the return of consumer lending, regulation that encourages free movement of investment dollars and more efficient and transparent processes. There’s the safety aspect too. For much too long people that cannot safely handle other people’s money were allowed seeming free rein. The good news is that there are clear signs that regulators, including the US Securities and Exchange Commission (SEC) and the UK’s fledging Financial Conduct Authority (FCA) are baring stronger teeth. Big firms are being penalised and hopefully among the talk of new and improved investor services, trust that clients will not be over-charged or cheated out of money will return. This edition carries many of these trends and themes. Mark Faithfull for instance looks at the return of the real estate segment, while David Simons looks at the ways in which transition managers are working to rebuild confidence in a segment scarred by bad, bad behaviour. For those players that have remained in transition management the going is tough as some clients have turned away from a service that should be an integral element of good portfolio management; and others have managed to avoid as asset allocation strategies have changed. We also carry two roundtables that underscore the dual themes in today’s financial market: the need to differentiate and specialise at the same time. Stand out services are no longer enough and so increased segmentation across operating business units, backed by continual investment in new technology, look to the be the order of the day. It’s no longer good enough for banks to look for clients: they have to be the right clients that can help them deliver growth across the span of business and this is clearly a challenge right now. Continuing our enhanced coverage of the post trade area our cover story this month looks at Russia’s National Securities Depositary, with a nod to the impact that the current slurry of activity in Crimea might have on the markets at large. Russia is clearly at a crossroads in its relationships with the global community. It will be interesting to see which dynamic wins through; one that harks back to the geostrategic and economic parameters of the 1960s; or the one that forges ahead in 21st century terms of reference.

Francesca Carnevale, Editor COVER PHOTO: Russian President Vladimir Putin gestures speaking at his meeting with Kazakh President Nursultan Nazarbayev and Belarusian President Alexander Lukashenko in the Novo-Ogaryovo residence outside Moscow at the beginning of March. As a counterweight to the European Union, Putin is pursuing an ambitious dream rooted in memories of Soviet glory: The Eurasian Union. It is a strategy straight out of the 1960s and at the core is an intent to pull former Soviet satellite states back into Moscow’s orbit. Photograph by Yuri Kadobnov, Pool, supplied by pressassociationimages, March 2014.

CONTENTS COVER STORY

RUSSIA’S INTERNATIONAL REACH

..............................................................................Page 4 How far can Russia’s geo-strategic plans impinge upon its efforts to become a key cog in the global investment machine. Can it achieve both ambitions, or will one or the other have to give? Either way, there is much at stake.

DEPARTMENTS

MARKET LEADER

US BROKING: THE RISE OF THE MIDDLE MARKET ...............................Page 13 David Simons looks at the new business strategies of US mid-market brokers.

TAKING THE MEASURE OF THE TOBIN TAX .............................................Page 17 Why mid cap stocks are sensitive to institutional-sized orders.

INSURERS UP SPENDING ON ANALYSIS .......................................................Page 18 Developing a more dynamic approach to data applications.

A ROTATION OUT OF EMERGING MARKETS? .........................................Page 20

IN THE MARKETS

The benefits, or otherwise, of tri-party collateral management structures

TURKEY: AT A WATERSHED? ...............................................................................Page 24 Mehmet Gun reviews Turkey’s political economy.

THE PERILS OF FORECASTING .............................................................................Page 27 What happens when central bank forward policy unravels.

FEAR AND LOATHING ON THE REGULATORY TRAIL

.......................Page 29 Why financial services think regulation is considered a strategic risk.

SPOTLIGHT

INVESTORS LOOK TO REAL ASSETS ...............................................................Page 30

THE BEAR VIEW

THE HUNT FOR REAL GROWTH .........................................................................Page 32

A roundup of market views and news.

What are the proper measures of growth?

BRICKS RETAIL KERB APPEAL AMONG CLICKS

REAL ESTATE

..........................................Page 33

The impact of online services on commercial property usage.

ALL THE REIT MOVES ..............................................................................................................Page 37 Have America’s REITS really run out of steam?

MARKET TRENDS – FIXED INCOME

LIQUIDITY RETURNS TO EUROPE’S PERIPHERY............................................Page 40 Neil O Hara explains why the euro crisis will change the MTN market forever.

SURVEY: MAPPING PENSION FUND SERVICE TRENDS ..........................Page 41 What Europe’s pension funds think about investment services provision.

WHAT’S EATING TRANSITION MANAGEMENT?

SECURITIES SERVICES

........................................Page 49

David Simons explains why TM is at a crossroads.

TRANSITIONING A MULTI-ASSET WORLD ..........................................................Page 53 The search for the perfect portfolio transition.

US SECURITIES LENDING ROUNDTABLE

............................................................Page 57

The search for liquidity and high quality assets.

MIFID II: ACHIEVING THE RIGHT LEVEL OF TRANSPARENCY? ......Page 67

TRADING REPORT

Ruth Hughes looks at the benefits or otherwise of the new directive.

THE TRADING TECHNOLOGIES ROUNDTABLE

............................................Page 71

How new trading technology is redefining efficiency and the search for liquidity.

MARKET DATA 2

Market Reports by FTSE Research ................................................................................................Page 82

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

COVER STORY

MANAGING CHANGE AND GEOPOLITICS IN RUSSIA

Russian President Vladimir Putin, centre, heads the Russian Security Council at the Novo-Ogaryovo residence outside Moscow on Thursday March 6th 2014. Photograph by Alexei Druzhinin, for the Presidential Press Service. Photograph supplied by pressassociationimages, March 2014.

RUSSIA: THE COST OF GEOPOLITICS What now for investors in the Russian market? The news as February closed was, clearly, not encouraging. Even though investors in Russia, and in emerging markets as a whole, look to have already positioned for the downside. The ruble has been selling off since the beginning of the year, though as March opened the currency fell 2.5% against the dollar and 1.5% against the euro, to a new all-time low; though it looked to have stabilised at the time of going to press. Francesca Carnevale looks at the implications of the crisis on investment in Russia in the near term and the country’s reforming institutions. USSIA’S HEIGHTENED MILITARY presence in the Crimea could be more costly than expected. As March opened, commodity prices were leading a charge of their own. Gold and silver futures rallied sharply on expectations that the crisis in Ukraine would run and run, ratchet-

R 4

ing up anxiety levels among investors already roiled over rising risks in emerging markets in recent months. The issue, sadly, is one of geopolitics rather than economic clout. Ultimately, Ukraine is a small economy which according to the 2014 Index of Economic Freedom, remains ‘repressed’.

Unemployment is running at 8% and annual GDP is running at just over $335bn. The country’s five year compound annual growth rate is minus-1% per year; though inflation is under control and averages 0.6%. Moreover, substantive institutional reforms are required for the country to aspire to more broadly based development and an inefficient legal framework remains highly vulnerable to political interference. Corruption is widespread and undermines the country’s already fragile rule of law. Clearly, escalating tensions in Eastern Europe have widespread implications for all parties. Economic growth in Russia has been laggard of late and money growth has slowed. Ruble depreciation may offset some of these trends; though the central bank’s target of 5% inflation by year end could be put under pressure by current events. Year on year consumer price inflation is around 6.1%, and given upward pressures from a falling ruble and a drain on inward money flows

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

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COVER STORY

MANAGING CHANGE AND GEOPOLITICS IN RUSSIA

Crimea’s prime minister Sergei Aksyonov, front centre, enters a hall prior the talks in Russian Parliament in Moscow, Russia, Friday, March 7th, 2014. Valentina Matvienko, speaker for Russia’s upper house of parliament says Crimea would be welcome as an “equal subject” in Russia if the region votes to leave Ukraine in an upcoming referendum. Russia’s parliament is planning to review a bill as early as next week that would speed up Crimea’s integration into Russia. Crimea would be the first territory to officially join Russia since the breakup of the Soviet Union in 1991. Photograph by Alexander Shalgin for Associated Press. Photograph supplied by pressassociationimages, March 2014.

explains the central bank’s move at the start of March to hike rates from 5.5% to 7%. The central bank’s move came at a time when Russian equities listed outside of the country were in comparative free fall, even including oil and gas plays (despite a rise in oil prices). Ukraine crisis has brought into sharp relief the dilemma facing the Russian government: continue on a path of integration with the West with its attendant financial benefits and give and take on long standing political alliances; or live within the parameters of 1960s Cold War geopolitics and face long periods of financial uncertainty until new alliances can be made profitable. It is a tough call. What does it all mean for Russia’s investment oriented institutions which have worked hard to establish international credentials? Is this a short term blip while Ukraine realigns its political geography and allegiances? Or, will all the

gains of the past few years be wiped out because of more overarching national political preferences? The outlook is cloudy. Certainly, “The probability of sanctions of some kind, this in a western bid to isolate (President) Putin, appear inevitable as fears of a new cold war build. And the risk of an isolated incident sparking actual conflict should not be discounted. But the West’s hands are partly tied by the strategic importance of Ukraine (certainly militarily, but also economically in terms of agricultural production and oil/gas distribution),” says Paul Locke, analyst at Westhouse Securities. Trust pricing, adds Locke, for those funds exposed to the region has thus far largely ignored impending risks, at least in relation to discount pricing. The only exception has been the diminutive Ukraine Opportunity Fund, which has actually seen its discount halve.

It is unlikely however that current international huffing aside, that Russia will move decisively down a path of military intervention outside the Crimea. Should the worst case occur, then markets across the globe will likely suffer sustained turmoil through the first half of the year, if note beyond. The most likely outcome is that Crimea will attempt to defect to Russia; short term tensions will rise as both sides in Ukraine stake their territory and military assets; the West will see saw between harsh words and light sanctions and ultimately everyone will come to terms with the new order. The same happened over Georgia. Those analysts predicting that Russia will be out in the cold for a decade will find that investors in search of returns will revert back to their investments and with some new geopolitical mapping aside, the world will return to near normalcy once more.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

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COVER STORY

MANAGING CHANGE AND GEOPOLITICS IN RUSSIA

Chart 1 GLOBAL FDI FLOWS: 2005-2013 Year

$ Billions

2005-2006

1494

2007

2002

2008

1819

2009

1221

2010

1412

2011

1691

2012

1317*

2013

1461**

Notes: Global foreign direct investment (FDI) inflows rose by 11% in 2013/comparable to the pre-crisis average. FDI flows to developed countries remained at historically low levels (39% of global flows) for the second consecutive year. Flows into the EU increased, while flows into the US continued to fall. Source: UNCTAD, Global Investment Trends Monitor, January 2014. * Revised figures; **Estimated figures

Europe and the United States will be careful to define their antipathy towards the expansion of Russian direct interests. Any sanctions imposed on Russia would see tit for tat responses that could turn off the supply of gas exports (worth around $30bn a year) through pipelines that run through Ukraine itself. Bund yields will be impacted short term and a flight to the dollar is inevitable impacting the euro and, possibly, sterling. In that regard, while the rhetoric might be tough, few countries in the West have any appetite for any further overseas military engagements. One important question is what else is out there to compensate investors backing out of emerging markets in general and out of Russia in particular? Investors looking to the United States in search of strengthening economic data might well be disappointed. The recent set of disappointing US economic indicators have sparked concerns that the US’s much vaunted economic recovery has lost momentum since the end of last year as inclement winter weather and indifferent economic policies have weighed on growth. Investors will also be looking to the US to see whether its

response to the Ukrainian crisis is robust or one of containment; until that is clear over coming weeks, markets will remain subdued at best. Ultimately, the question is not whether the crisis will escalate but how long the current impasse will continue and whether the tense concentration of armed soldiers on both sides will be upended by an explosive trigger from paramilitary pressure groups. If the conflict does escalate, Europe’s debt and foreign exchange markets will be impacted sharply. Russia eurobonds, CDS, and OFZs, which have lagged the weakness in the ruble significantly so far will see outlows and the Russian central bank could end up having to support the currency further. Eastern European economies (particularly Hungary, which has some large local issuance requirements in 2014) would be

impacted negatively. Poland, Turkey, South Africa and other historically high growth markets could be in for battering as higher energy prices damage already tested current accounts.

The Russian economic story Ultimately the current crisis is unlikely to upend Russia’s long term growth story. Ernst and Young’s 2013 Russia attractiveness survey, found that while the country still faces challenges, it remains an attractive destination for foreign direct investment. Its growing consumer market, rising disposable income, skilled workforce and vast natural resources propelled it up UNCTAD’s league table of FDI inflows (please see Chart 2) from ninth to third place last year. Administrative barriers and corruption continue to limit opportunities for Russia in attracting more FDI, however the government’s

Chart2 FDI INFLOWS: TOP 20 HOST ECONOMIES 2013 (Billions of dollars) 2013 Rank

Country

United States

$ Billions 159

2012 Rank 1

China

127

Russia

British Virgin Is

Hong Kong

Canada

Brazil

Singapore

United Kingdom

Ireland

Australia

Mexico

Spain

Germany

Luxembourg

198

India

Netherlands

Chile

Belgium

200

Indonesia

Source: UNCTAD, Global Investment Trends Monitor, January 2014 Notes: In 2013, the shift in market expectations towards an earlier tapering of quantitative easing in the United States caused some volatility for international investments. The impact was large in some emerging markets, which suffered real exchange rate depreciation, stock market declines and a withdrawal of capital. However, in contrast to foreign portfolio flows that declined dramatically in the second and third quarter of 2013, FDI flows were relatively less volatile.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

Post-trade made easy

COVER STORY

MANAGING CHANGE AND GEOPOLITICS IN RUSSIA

US Secretary of State John Kerry and French Foreign Minister Laurent Fabius (front right) depart after a meeting on the Ukraine crisis with Russian Foreign Minister Sergei Lavrov and other foreign ministers in Paris, Wednesday, March 5TH 2014. Russia is unlikely to pull back its military forces in Ukraine’s Crimean peninsula, analysts and former Obama administration officials say, forcing the United States and Europe into a more limited strategy of trying to prevent President Vladimir Putin from making advances elsewhere in the former Soviet republic. Photograph by Kevin Lamarque for the White House pool. Photograph supplied by pressassociationimages, March 2014.

efforts to modernise the country’s capital markets infrastructure and the institutions that embody it have encouraged investors (both direct and indirect) to leverage the country’s potential. The shift was also influenced by the UK’s energy major BP taking an 18.5% stake in Rosneft as part of Rosneft’s $57bn acquisition of TNK-BP. “FDI in the Russian Federation is expected to keep pace with its 2013 performance as the Russian Government’s Direct Investment Fund [RDIF]—a $10bn fund to promote FDI in the country— has been very actively deployed in collaboration with foreign partners, for example funding a deal with Abu Dhabi’s Department of Finance to invest up to $5bn in Russian infrastructure,” the report says. The RDIF says it sealed six long-term investment contracts worth above $8bn last year, which also included deals with the Japan Bank for International Cooperation, France’s Caisse Des Depots International, Italy’s Fondo Strategico Italiano and the Korea Investment Corporation.

Recently Russia has also been showing better results in business rankings. In 2013 the country jumped 20 points in a World Bank’s Doing Business rating, having shown the best dynamics among BRICS countries. Also at the beginning of 2014 Russia broke into Bloomberg’s 50 best countries for doing business. Globally, in 2013 FDI reached pre-crisis levels, rising 11% to an estimated $1.46trn, according to UNCTAD figures. Developed economies attracted a historic low share of foreign investment, while FDI to the emerging markets reached a new high of $759bn, or 52% of the global inflow.

Opening up the capital markets The crisis has come at a time when the government has steadily opened up the country’s capital markets to foreign investment. The Russian bond market, which historically has in the near past offered better yields compared to Europe and the United States, is now completely open to foreign investment dollars. Following the introduction of

simpler procedures for bond trading via the Euroclear and Clearstream depositories, foreign investors now have direct access to the domestic Russian bond market. January was a busy month for Russia’s National Securities Depositary (NSD), with agreements signed with global post trade leading lights Euroclear and Clearstream covering cross border services for Russian corporate and municipal bonds. The NSD is setting a blistering pace of change, though currently the initiatives are outstripping investor interest in the Russian market. As of the end of January this year investor clients of Euroclear and Clearstream can buy Russian corporate and municipal bonds without having to set up Russian subsidiaries or opening special accounts with Russian banks. Until the agreements came into force foreign investors only had indirect access to the Russian bond market. For example, Clearstream allowed its customers to buy Russian bonds using a Deutsche Bank subsidiary in Russia as an intermediary. Both Euroclear Bank and Clearstream have now opened accounts with Russia’s central securities depository (NSD), allowing all Euroclear Bank and Clearstream clients investing in Russian corporate and municipal debt to settle those trades and deposit their positions with either Euroclear Bank or via Clearstream’s ‘Bridge’ arrangement. The agreement will facilitate the settling of transactions between accounts at the various CSDs and help increase liquidity flow in the Russian market. “Following on from the success of our OFZ service, we … now offer services for municipal and corporate assets. The growing appetite shown by investors to mitigate risks while ensuring a solid return on their diverse portfolio of assets is now further enhanced with access to many of Russia’s companies,” explains Frederic Hannequart, chairman of Euroclear Bank.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

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COVER STORY

MANAGING CHANGE AND GEOPOLITICS IN RUSSIA

The new service complements the NSD’s separate and existing agreements with Clearstream and Euroclear Bank that were finalised in February of last year in support of Russian government bonds (OFZs). Municipal bonds and corporate bonds issued in 2012 and later are eligible for the service. Euroclear Bank’s service for OFZs (and now corporate and municipal debt) is part of a progressive suite of services which aims to expand Euroclear Bank clients’ access to Russian securities, including a service for Russian equities which is scheduled to go live in the second half of 2014. OFZs, corporate and municipal securities held in safekeeping by Euroclear Bank will also be eligible as securities collateral for securitised transactions where Euroclear Bank is the tri-party collateral management agent. The introduction of settlement for

corporate Russian bonds, coupled with a firm commitment to establish the Bridge between the ICSDs in the Russian market will help further develop the market infrastructure needed to offer investors and issuers an enhanced offering in the Russian capital market. Prior to the crisis, the share of foreign investment in OFZ government bonds has gone up by circa 25%, according to the Bank of Russia, since the establishment of new financial market infrastructure in Moscow. As a next step, Clearstream will look to offer settlement for equities via its direct link to the NSD, due for summer 2014, in line with expected changes to Russian legislation. This looks likely to continue despite current market strains. All parties and politicians are aware of what is at stake: the pace and depth of Russia’s rising investment market.

Just how important international links are to the overall process are stressed by finance minister Anton Siluanov, who explains that:“significant changes have been introduced to Russian [financial market] legislation, and in particular to the Tax Code, to the Securities Market Law, and the Law on Joint Stock Companies. I am confident that this is an important step towards establishing an International Financial Centre (IFC) in Moscow that aims at providing better accessibility and lower cost of long-term financing for Russian companies.” Certainly, this level of market deepening is a pre-requisite for the Russian market. As a result of the changes, international investors’ share of the Russian corporate bonds market could triple to 10% over the next two or three years, an increase of $10bn to $15bn in absolute terms, adds Siluanov. I

A new and improved code of corporate governance has been agreed by Russian ministers and financial market participants at a government meeting in Moscow. Andrew Neil reports.

RUSSIA STEPS UP CORPORATE GOVERNANCE EFFORTS R

ussia’s new corporate governance code are designed to protect minority shareholder rights and expand the role of boards of directors in governance of listed companies. One of the most important changes introduced by the does is the definition of criteria by which board members can be defined as independent Significant alterations were made to the section of the code on the creation and functioning of risk management and internal control systems. Also covered are new approaches to remuneration for directors and executive body members, as are procedures for creating board

committees on audit, remuneration, and personnel. Moscow Exchange chief executive officer Alexander Afanasiev explains that, "The code will not be obligatory; however, I am confident that companies that adhere to it will be rewarded with investors’ trust, and access to less expensive and longer term sources of financing.” Afanasiev explains that investors in Russia’s growth story are much more discerning today. He notes that they are “less aggressive than they were ten or so years ago, when they came to the Russian market and forgave much, including corporate governance shortcomings, in

return for growth prospects. The situation today is different, and [local] companies need to comply with high standards and modern corporate practices. Improvement of corporate governance in Russia is the single most important area of the programme to modernise the Russian financial market and improve the investment climate." The new code was developed with the involvement of the CBR, the Organisation for Economic Co-operation and Development (OECD), the Moscow International Financial Centre taskforce, Moscow Exchange, and representatives of Russia’s largest issuers.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

MARKET LEADER

THE MIDDLE MARKET MAKES ITS MOVE With the ability to focus on a select group of verticals while offering an array of valued client services, various mid-tier investment houses have managed to achieve respectable profitability, and without bulge-bracket sized overhead. How does the rise of the middle market shape the industry’s broking dynamic and what are the keys to sustained success? Dave Simons reports. AVING WEATHERED A lull in M&A activity as well as increased consolidation among bulge-bracket firms, in recent times leading middle-market brokerages have begun to reassert themselves, and, in the process, have become a viable foil for their top-tier peers. Names such as William Blair, Stifel Nicolaus and RW Baird have beaten the odds and risen to prominence by offering a diverse array of client-valued services, from M&A advisory and deal financing to wealth management and more. At the same time they have expanded their coverage through acquisition and partnerships—all during a period that was not nearly as favourable to larger brokerage firms.

The movement in the broking middle market comes during a period of profound change within the investment banking industry at large. While the segment will undoubtedly remain vital, the double-digit returns on equity that marked the heyday of investment banking are likely a thing of the past, suggests Boston Consulting Group’s Philippe Morel, senior partner and a co-author of the BCG report Survival of the Fittest: Global Capital Markets 2013. Continued downward pressure could send additional players off the pitch entirely while forcing others to make smarter strategic choices, including reducing exposures to unprofitable areas while (at the same time) beefing up proven revenue-generating segments. On the bright side, BCG says

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

THE RISE OF THE US MID-MARKET BROKER

Photograph © Jason Smith/ Dreamstime.com, supplied February 2014

that advisory specialists—those that can offer top-shelf counseling particularly with respect to capital structuring and M&A—will be among the business models most likely to succeed in the coming years. The ability for small to mid-sized brokerages to focus on a select group of specialised investment strategies has enabled many of these players to maintain respectable profitability without having bulge-bracket sized overhead. Even so, with the need to fund newer technologies and maintain capital reserves for potential acquisition targets, size continues to be a key factor—hence the continued advantage held by well-capitalised firms with diversified business models. “If you are not growing, you are moving backwards,” offers Mike McGill, co-founder and managing director of middle-market investment bank MHT-Midspan, the product of a year-end merger between San Francisco’s MidSpan Partners and Dallas-based MHT Partners. In a recent CNBC opinion piece, McGill, whose firm focuses on verticals such as technology, education, healthcare, and energy services, suggested that the quest for increased specialisation within the middle-market firms has touched off a“consolidation scramble,” as companies look to build scale needed to handle a greater share of verticals coverage. Such has been the case with St. Louis-based investment bank Stifel Financial, which, unlike some of its mid-tier peers, has survived the barbelling of the brokerage industry due in large part to an unusually aggressive acquisitive streak. Following the 2010 purchase of San Francisco’s independent investment bank Thomas Weisel Partners, in 2012 Stifel plunked down an estimated $575m for struggling New York-based M&A advisory firm KBW; early last year the company procured the domestic fixed-income business of Knight Capital, following an infamous trading-software glitch that cost the

MARKET LEADER

THE RISE OF THE US MID-MARKET BROKER

well-known New Jersey market maker some $440m in a single day. Stifel, which offers securities brokerage, investment banking, wealth management and other services, also served as book runner for a succession of bank IPOs during 2013. Stifel remains focused on growing its advisory segment, and with market fundamentals improving, continues to be optimistic about the outlook of its business, Ronald Kruszewski, Stifel chairman, president and chief executive officer said during a recent conference call. Indeed, Stifel’s third-quarter numbers —total revenue of $478.6m, a 15.6% year over year increase—reflect a continuation of the company’s impressive growth trajectory. In its January equities-research report, Citi analysts noted that Stifel’s spate of acquisitions “have focused on scale build within the institutional business,” and indicated the payoff could be significant“should operating conditions improve as well as from efficiency gains as management focuses on expense rationalisation”. Whether due to luck, wisdom or a combination of both, Stifel has been better managed than many of its midmarket brethren, and thus appears “poised for opportunistic growth,” sums up Michael Wong, stock analyst for Morningstar in a recent overview. The company has one of the best business mixes in the investmentbanking industry, contends Wong; its emphasis on wealth management, which at present supplies Stifel with over half of its net revenues, seems particularly astute, one that could pay further dividends should the markets continue their upward momentum and subsequently increase asset-management levels. To date Stifel has been able to silence those who have questioned the firm’s seemingly compulsive buying habit. Going forward, much will depend on Stifel’s ability to continue to grow faster than it spends, particularly given its relatively lofty share price

Milwaukee-based RW Baird, which has used strategic partnerships to bolster its electronic-trading capabilities while also investing in new sales and tradeexecution operations within key American markets. Like others in the mid-tier, Baird continues to beef up its equity research capacity, growing its coverage by some 40% over the last five years. “It hasn’t just been growth for growth’s sake,” explains Jon Langenfeld, Baird head of global equities and director of equity research, “these are areas where our clients want and need our expertise. We wouldn’t be able to sustain this kind of growth if our clients didn’t trust and value us.” Mike McGill, co-founder and managing director of middle-market investment bank MHT-Midspan. Midspan is the product of a year-end merger between San Francisco’s MidSpan Partners and Dallas-based MHT Partners. In a recent CNBC opinion piece, McGill, whose firm focuses on verticals such as technology, education, healthcare, and energy services, suggested that the quest for increased specialisation within the middlemarket firms has touched off a “consolidation scramble,” as companies look to build scale needed to handle a greater share of verticals coverage. Photograph kindly supplied by Midspan, February 2014.

(Stifel briefly touched $50 in late January, before pulling back with the rest of the market). “Integrating recent acquisitions is likely to depress earnings in the near term,” suggests Wong. Though an expected rebound in financial-service industry capital-markets activity should boost revenues within the acquired firms, until Stifel is able to completely rationalise its expense structure, “the acquisitions will add little to, or even reduce, overall company earnings,” notes Wong. Additionally, firms such as Stifel could be vulnerable to new rules that impose a fiduciary restriction on broker financial advisors with respect to the sale of certain highmargin investment products. Also improving its standing has been

M&A on the way It may take some doing for the middle market to mount a serious challenge to the industry’s biggest wigs. Despite high hopes at the outset of 2013, US mid-market deal volume ultimately pulled up short for the whole of the year. In 2013 middle-market deal making fell to $246bn (as of midNovember) versus $308bn for 2012, the segment’s weakest showing since 2009, according to research from NASDAQ OMX (which published its year-end survey The Mid-Market: M&A’s Core in conjunction with financial-data provider Mergermarket). Persistent concerns over domestic growth, in addition to steeper valuation multiples due to rising stock prices, were among the elements weighing on mid-market deal making last year. To date the Americas accounts for roughly 35% of global mid-market transactions, according to the report. Those figures could improve over the next ten months, however, particularly if economic conditions continue to trend upward.“Strategics have considerable cash piles and private equity is sitting on a significant amount of dry powder,” notes NASDAQ. Despite the predominance of bulge-bracket deals during the past year, NASDAQ says the mid-market remains “the bedrock” of M&A activity worldwide, particularly around deals in the $10m-$250m range.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

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dŚĞ D ĂůŐŽƌŝƚŚŵ ŝƐ ƵƐĞĚ ŝŶ ƌĂĚŝŽ ĂƐƚƌŽŶŽŵǇ ƚŽ ĐůĂƌŝĨǇ ƚŚĞ ŽďũĞĐƚƐ ƵŶĚĞƌůǇŝŶŐ Ă ŵĂƐƐ ŽĨ ĚĂƚĂ͖ ǁŝƚŚ ŝƚƐ ĂďŝůŝƚǇ ƚŽ ŚĂŶĚůĞ ŵŝƐƐŝŶŐ ĚĂƚĂ ĂŶĚ ƐŚĞĚ ůŝŐŚƚ ŽŶ ƵŶŽďƐĞƌǀĂďůĞ ǀĂƌŝĂďůĞƐ͕ ŝƚ ŝƐ ǁĞůůͲƐƵŝƚĞĚ ƚŽ ƉƌŝĐŝŶŐ ĂŶĚ ŵĂŶĂŐŝŶŐ ƚŚĞ ƌŝƐŬ ŽĨ ŝŶǀĞƐƚŵĞŶƚ ƉŽƌƞ ŽůŝŽƐ͘ dŚĞ D ƉƉůŝĐĂƟ ŽŶƐ ƌŝƐŬ ŵŽĚĞů ĂŶĚ ĂƩ ƌŝďƵƟ ŽŶ ƚĞĐŚŶŝƋƵĞƐ ĂƌĞ ďĂƐĞĚ ŽŶ ŽƌŝŐŝŶĂů ǁŽƌŬ ďǇ ů ^ƚƌŽǇŶǇ ĂŶĚ ƌ dŝŵ tŝůĚŝŶŐ͘

ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

MARKET LEADER

THE RISE OF THE US MID-MARKET BROKER

A new survey conducted by KPMG affirms these sentiments. While also noting the various blockbusters that dominated the outgoing year, 2014 will nonetheless belong to the middle market, according to 77% of KPMG respondents, who anticipate the majority of deals falling in the sub$250m range. After a middling 2013, the US and North America will lead the way in mid-tier activity, paced by a stronger economy and comparatively robust GDP. “In today’s volatile economic environment, the perceived safety of the North America market continues to attract investment dollars from both US and global companies looking for predictable growth,” observes Phil Isom, head of KPMG Corporate Finance LLC.“Even though indicators of global economic improvement are evident, smaller deals remain easier to finance and integrate.” Adds Dan Tiemann, KPMG’s Transactions & Restructuring lead for the Americas, “We have seen a shift in the marketplace from when companies divested non-core assets as a result of the economic downturn to today, pursuing

inorganic growth. With favourable conditions in place for increased M&A activity, such as significant cash on corporate balance sheets, more confidence in the overall economy, and continued low interest rates, expanding core business functions through acquisitions is an appealing strategy for organisations.”

EPS growth accelerates Prospects for the small- to mid-cap (SMID) corner of the market seem particularly rosy at this juncture. Whereas current-year large-cap earnings growth could trail 2013 levels due to flat netinterest margins and fee income, conversely EPS growth within the SMID cap space is expected to accelerate, according to Stifel-KBW research, led in part by expanding mid-sized M&A activity; the segment will also benefit from greater use of leveraged capital, compared to the more regulated bulge-brackets. “M&A is an avenue for banks to drive improved operating leverage, earnings, efficiency and scale,”says Ben Plotkin, executive vice president, KBW

and Stifel vice chairman. Furthermore, ongoing regulatory pressure faced by the industry’s largest banks including more stringent capital and liquidity requirements will promote further growth within the mid-tier, paving the way for additional acquisition opportunities, he adds. While touting the benefits of being not-quite-so-big, Plotkin concurs that problems can arise for middle-tier firms without a proper expansion plan. To wit, some IBs may have grown to the point where they may fall under the same regulatory purview as their toptier peers, yet lack the wherewithal to cover the cost of top-tier reporting and compliance mechanisms. The answer? Keep on growing, says Plotkin. “The most cost-effective method to reduce the regulatory burden is to seek scale.” Looking ahead, Plotkin sees the scale challenges for smaller banks combining with the regulatory challenges for the biggest banks to create a “sweet spot” for those in the $5bn to $10bn asset range—and with higher earnings multiples to boot. I

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FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

IN THE MARKETS

Taking the measure of the Tobin Tax in Italy N THE SIX years between the first implementation of the Markets in Financial Instruments Directive (MiFID) and last month’s agreement on MiFID II, the structure of European markets has irrevocably changed. Legacy structures have toppled, and new pools of liquidity, made available by entrepreneurial new pan-European venues, have now given investors more choice. In a period of rapid change, Italy’s key position at the heart of European markets’ infrastructure has continued. Italy remains the largest market in Europe in terms of volume of shares traded; according to BATS Chi-X Europe data, over 600m trades are executed each day, with retail investors responsible for up to 70% of intraday trading. Moreover, there is a compelling case for accessing Italy. The FTSE MIB index has risen by 23.01% in the last two years. In the six months to 24 January 2014, it added gains of 20.50%. However, the controversial financial transaction tax, first introduced in March 2013, threatens to depress the country’s intraday trading tradition. The tax on equities levies 0.10% per exchange transaction and 0.20% on over-the-counter trades. The corresponding derivatives tax levies a fixed charge per transaction, ranging from €0.01875

to €200 depending on the instrument type, with a significant tax discount if the orders are traded on exchange. Transactions generated by algorithmic trading incur an additional charge of 0.02%, though activities deemed to be market-making are exempt. While the public and political will may have been broadly justified, the unintended consequences are biting harder than expected. By increasing the cost of investing, known as frictional cost, the Tobin Tax materially affects volumes and returns. In some cases this forces investors to look beyond Italy’s borders and so could restrict Italian corporates from benefitting from broader European investment growth. The first consequence, declining volume, has already taken hold. When the equities tax was introduced in March last year, the average daily value of trading of Italian shares across 11 European venues fell 12% to €2.72bn compared to January and February. By comparison, average daily trading across Europe as a whole increased by 9% to €35.1bn. By September 2013, six months after the tax’s introduction, Italian trading volumes had dropped below 5% of total European equity trading market share for the first time in five years, according to data com-

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

ITALY AND THE FTT TAX: TOBIN OR NOT TOBIN?

Italy introduced a domestic tax on financial transactions (FTT), the so-called Tobin Tax, on financial transactions in two batches, in March and July, last year. Then, in early September Italy became the first country to extend FTT to high frequency share trading. The government wanted to utilise the tax to reduce financial speculation, raise revenue and ‘stabilise’ markets. The Tobin Tax was originally devised and promoted back in the 1970s ostensibly to stabilise currency markets following the collapse of the Bretton Woods system in 1971. Is the tax really relevant today? Does it do more harm than good? Alex Dalley, co-head of sales, BATS Chi-X Europe looks at the impact of the tax.

piled by Rebecca Healey, senior analyst at research consultancy TABB Group. Clearly, the tax is dissuading otherwise normal trading behaviour. This presents a problem for the economics of the tax itself: already at a lower level, the declining activity makes it unlikely the government will generate its target income. This creates a second issue with Italy’s Tobin Tax. It charges investors to invest in Italian corporates. Put simply, why would an investor consider Italian stock with a 0.12% levy, when they could invest in a German stock without the added cost? This is an unnecessary impairment to well-capitalised, well-governed Italian corporates that could normally benefit from broader sector-led investment. The Tobin Tax creates an unhelpful disincentive to own the equities issued by these firms. So, while political understanding plays catch-up with the economic case against the Tobin Tax, there are measures investors can take to benefit from the latest trading and investing opportunities in the new pan-European paradigm: whether they want to invest close to home or further afield.

Find the friction The first step should include a thorough appraisal of trading processes. High frictional costs, that damage both margins and returns, are endemic within the trading system, particularly within historic incumbent models, and can be levied on anything from the trades themselves to market data fees. On the flipside, maker-taker pricing provides rebates for those injecting liquidity into the market. In effect, this rewards passive investors when trades are executed, and so presents an incremental (if small) benefit. Market data remains one of the highest frictional costs incumbent exchanges charge. For example, Borsa Italiana charges €40 per month to view their order book, of 326 securities (commonly called Level 2 data), working out at just over €0.123 per security. At BATS Chi-X Europe

IN THE MARKETS

ITALY AND THE FTT TAX: TOBIN OR NOT TOBIN?

(BATS), €53 gets customers a view of the entire universe of the 3,600 European stocks we trade, or €0.015 per security. The recent launch of BXTR, the firm’s trade reporting service, means it is also able to provide data on 10,000 securities traded OTC at no extra cost. When you consider these fees apply for each ‘screen’ of data, and particularly given preponderance of small-scale retail investing in Italy, a compelling case forms for considering different providers. Additionally, the more you cut frictional cost, the better you achieve best execution.

Consider your clearing Retail investors rely on cheap access and so cost-effective clearing is an essential constituent in reducing the cost of trading. There are moves toward interoperable clearing, and this will allow margin efficiencies to be realised for Italians trading non-Italian markets. Although there will still be considerable settlement fragmentation (for example, if an Italian-based broker buys German shares and clears them through CC&G, they will still need to settle in Clearstream—Germany’s CSD —and then be transferred to their account with Monti Titoli), this presents the possibility of a real step forward. Of course, one solution is to look beyond Italy’s borders. A wealth of options exist outside Italy and by accessing a broader range of European securities, Italian investors can diversify their returns from those offered by just their domestic market. To do this either requires multiple connections to multiple national incumbent exchanges, or one connection to a pan-European exchange, such as BATS Chi-X Europe. Choose one pan-European exchange, and you generate more opportunities for netting. These stages may not provide the panacea investors need to fully insulate themselves against Italy’s Tobin Tax, but they are a starting point in mitigating its more negative effects, and maintaining Italy’s primacy at the forefront of European retail marketplaces.

According to a new report from State Street, only 13% of insurers surveyed consider their firms’ enterprise-wide data management to be a significant strength and only 19% are confident in their multi-asset risk tools, the lowest proportion of respondents from a pool of asset managers, asset owners and alternative managers. However, insurance executives say they recognise the need for better, stronger data systems, with 82% of respondents citing data and analytics as a key strategic priority for their business.

INSURERS UP THEIR SPEND ON DATA & ANALYTICS NSURANCE FIRMS STAND or fall by their ability to identify and help manage the risks their clients face, though the nature of the risks insurers need to manage is changing. On the investment side, insurers face chronically low interest rates and fluctuating equity market returns, which in turn makes traditional investment portfolios (typically 60/40 equity/bond allocations) increasingly obsolete. Clearly, insurers need a more dynamic approach to meet their liabilities, which might involve increasing investment alllocations to more complex asset classes. To manage risk effectively across a highly diversified multi-asset class portfolio, insurers need timely, accurate data and to be able to test different investment conditions quickly and efficiently. Compliance with regulation is, of course, also important, with Solvency II

for instance, setting exacting new standards for the way insurers manage data. With these trends in mind, insurance firms look to be increasingly reliant on data and analytics. This accords with a new report from State Street that surveyed more than 400 insurance executives about their capabilities in this area. However, only 13% of insurers surveyed considered their firms’ enterprise-wide data management to be a significant strength to meet changing market conditions and only 19% say they are confident in their multi-asset risk assessment tools. According to the report, investment in data and analytics among insurers is expected to grow. An overwhelming majority of respondents (81%) say they intend to increase spending on data initiatives in the coming years. State Street saw a threefold increase in the number of insurance clients in 2013, demonstrating the growth in popularity of data-driven risk solutions amongst insurers. “Fundamentally transformed markets, a push into new asset classes and a more stringent regulatory environment are all accelerating change and contributing to a rise in demand for data and analytics capabilities amongst insurers,” explains Jeff Conway, executive vice president and head of State Street Global Exchange. “Risk management has always been at the nexus of underwriting and investment, and insurers know what is at stake. The challenge ahead is how to turn fragmented IT systems into a strong and flexible platform capable of adapting to the demands of a more complex investment climate.” “To build an effective data driven business for 2014 and beyond, insurers should focus on building a stronger foundation,” adds Scott FitzGerald, executive vice president and head of State Street Sector Solutions, Americas.“They can do this by improving risk tools with multi-asset class capabilities, developing solutions to manage regulation globally, accelerating investment decisions, and developing a scalable data architecture.” I

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

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IN THE MARKETS

EMERGING MARKET INVESTMENT INFLOWS

Photograph © Daniela Mangiuca/Dreamstime.com, supplied February 2014.

A ROTATION OUT OF EMERGING MARKETS? Specialist asset managers say this is a great time to buy selected corporate stocks in emerging markets; particularly those linked to firms that serve and service the burgeoning middle class income segment. It is a message however that has largely escaped investors at large who remain jittery about the near term prospects for emerging markets and have continued to pull out money from the segment for almost four straight months. How wounded is the segment and what is needed to shift money back into the emerging market story? S EQUITY VALUATIONS in Europe and the United States have become more attractive as economic recovery gains momentum investors look to be shifting allocations out of emerging markets. Reasons for the shift are manifold. The winding down of the US Federal Reserve Bank’s quantitative easing program and continued worries about China’s economic growth rates have kept the pressure on emerging markets currencies and interest rates. Moreover, recovery in Europe and the US is

gaining momentum and earnings growth is expected to accelerate through this year. That has mean that equity valuations in older markets have become more attractive. January was particularly bloody. As Kathryn Langridge, manager of the Jupiter Global Emerging Markets Fund (and who was recently appointed comanager of Jupiter’s Emerging European Opportunities and Jupiter New Europe funds alongside Colin Croft) tells it, “A sequence of locally painful but unrelated events in

Argentina, Thailand, the Ukraine and China led to the intensification of a sense of crisis. Turkey has been particularly vulnerable. With an external deficit approaching 7% of GDP, it has suffered a reversal of short-term capital flows. The central bank has been forced to spend dwindling reserves on supporting the currency, which has experienced significant depreciation since political tensions resurfaced in December last year. Other currencies are also experiencing contagion, including the South African rand, the Brazilian real, the Indonesian rupiah and the Russian ruble.” The temperature remained cool across the board. EPFR tracked emerging market equity funds reported investors pulling out over $4bn over the two weeks to end January. Of this figure, just under half ($2bn) looked to be retail investors, who last committed money to the fund group in the early part of the second quarter last year. The data provider, which is a subsidiary of the Informa Group, reports that the outflow of retail funds out of emerging markets was the largest directional flow since August 2011. Most commentators maintain that the outflow is cyclical rather than systemic; even so some serious numbers have been thrown into the trend mix. Various Bloomberg reports, for instance, have suggested that some $20bn has moved out of emerging markets over the last 13 months, of which $10bn has flown out of the emerging markets since the beginning of December last year. According to Stephen Derkash, head of the UBS Asset Management Emerging Markets Small Caps fund, “the percentage of fund managers that are underweight emerging markets stocks is the highest for 12 years. China’s hard landing is the big concern.”

Negative RMB flows Among reporting fund groups geared to the Asian markets China equity funds reported negative renminbidenominated flows, says EPFR. In a

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

Opinions do count.

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IN THE MARKETS

EMERGING MARKET INVESTMENT INFLOWS

counter-trend however won-denominated commitments were at a six week high in early February high with Korea equity funds posting their biggest inflow since late December. Funds dedicated to Thailand had a time however despite being one of the better performers, with redemptions the biggest in over a decade as voters in the politically divided country headed to the polls, and outflows from India equity funds hit their highest level since the third quarter of 2011. Russia too has not escaped investor opprobrium; no surprise given economic indicators have weakened and in portfolio composition in recent transactions Russia is showing slightly worsening trends. Nonetheless, Moody's expects the performance of Russian RMBS and ABS transactions to remain relatively stable. The drivers of this stability are positive but slower than initially forecast real GDP growth at around 2% and a continued rise in house prices. Moody's says that issuance will increase slightly in 2014, largely because Russia’s state-owned agencies AHML and VEB will continue to support the RMBS market; and secondly that private investors are entering the market. Private investors are expected to become a noted feature in the Russian investment market through this year. Moreover, the continued expansion of the Russian mortgage market will build on momentum from 2013. Last year, this market hit new highs due to new entrants and new products, and continued the rapid growth that commenced after the end of the 2008/2009 financial crisis, says Moody’s. Underwriting standards generally remained tighter than before the crisis, but increased competition between mortgage lenders implies that standards could be showing signs of deterioration. However, the quality and quantity of information available to originators has improved because the use of credit bureaus has become standard practise. It is not without risk:“The lack of transparency surrounding grey income, the

inaccuracy of credit records, the possibility of overvaluations, and the appearance of riskier mortgage products all pose credit risks,” says a Moody’s analyst. By mid-February, various European emerging markets indicators marked something of a return to form, according to Platon Monokroussos, head of global markets at Eurobank Global Markets Research in Athens, emerging European equity markets closed broadly higher mid-month on improved global risk sentiment, “with bourses in the CESEE region receiving additional support from upbeat domestic Q4 2013 GDP data. In detail, Turkey’s BIST 100 posed among the region’s main outperformers with a 1.75% jump on reportedly easing corporates’ [sic] demand for hard currency. Hungary’s BUX bounced by 1.23% after real Q4 2013 GDP came in at 2.7%Y year on year, exceeding the market’s median forecast of 2.1% year on year. Against a similar background, the majority of CESEE currencies firmed. The Hungarian forint led the gains in the region on the back of better than expected GDP data. The EUR/HUF eased to a near two-week low of 307.89 intraday, remaining however within distance from a two-year peak of 314.53 hit earlier in the month amid concerns about the country’s high debt levels and persisting expectations for further monetary easing ahead”.

See-saw effect This see-saw effect simply underscores Langridge’s view that emerging markets economies continue to offer upside potential in spite of obvious glitches. First off is the obvious assertion that trend growth in the segment remains greater than that of the advanced economies and would accelerate if necessary structural reforms were implemented and if political events in countries such as the Ukraine did not exacerbate investor jitters over their emerging market allocations. “There is clear evidence of serial economic mismanagement in a number

of emerging economies, the extreme frailties of Argentina, for example,”concedes Langbridge. However, she stresses, “A number of countries are closer to addressing the structural problems that have led to the recent suppression of economic growth potential. Mexico, under the now established administration of Enrique Pena Nieto, has embarked on an ambitious programme of financial, energy and tax reform within the framework of a balanced budget and low debt levels.” Investors, she says, “should look beyond immediate problems and at where the long term opportunity is and focus on quality investments in emerging markets firms that can take advantage of sector growth opportunities and changing patterns of consumption.” Langbridge points to China as a template. “The unexpected decline in a key measure of economic growth in China, the manufacturing sector’s purchasing managers’ index, has exacerbated fears of a slowdown at a time when money market rates have spiked,” she says. That jump in costs though is largely due seasonal factors associated with Chinese New Year and a crude attempt by the authorities to bring credit under control, which comes at the expense of some economic growth, she explains. Langridge believes that the recent bailout of a trust loan product is an indication that China is looking seriously at broad economic rebalancing and concedes there remain persistent and valid concerns about the ability of some financial companies in the republic to manage credit risk. In November last year China announced a new blueprint for its future, known as ‘The Decision’, which involved some 60 separate proposals across a spectrum of issues which could have dramatic consequences in areas including health care and social security, justice and the rule of law, intellectual and physical property rights, banking and monetary policy, as well as environmental protection.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

The proposed changes, intended to facilitate sustainable economic growth, involve reforms to state-owned enterprises, improving their professionalism and efficiency in resource usage. There are also measures aimed at encouraging enterprise and innovation, as well as blocking unfair competition, which could speed up the process of rebalancing the economy away from investment-led growth and toward a more entrepreneurial, consumerfocused and service-oriented model. The project has a decade-long time frame, even so some benefits will flow through in 2014, with the expected expansion of the country’s free trade zones (such as the one announced for Shanghai in late 2013).“Stepping back, the process of monetary normalisation driven by the Chinese authorities is a reflection of the underlying strengthening of the global economy, which in our opinion will ultimately be interpreted positively for growth, rebalancing and recovery in emerging markets,” says Jupiter’s Langridge.

Secular growth Derkash at UBS Asset Management concurs, explaining that he expects emerging markets to remain a secular growth story for at least another decade. “That secular growth is what we’re after,” he avers. He concedes however that he remains in a relatively sweet spot in that alpha opportunities in the small cap segment have been much higher than in the large cap sector over the last three years: “it is a very inefficient asset class and therefore a very attractive space.” A bottom up, fundamental stock picker, Derkas has utilised the MSCI emerging markets index as a benchmark for the application of his investment approach, which he says enables him to choose 80/90 of the benchmarks best stocks. “It’s purely a stock pickers’ portfolio,” he says. The MSCI, like the FTSE have broad brush emerging markets stock indices, which include representation from the BRIC markets as well as other high

Stephen Derkash, head of the UBS Asset Management Emerging Markets Small Caps fund.

growth market plays such as Mexico, Indonesia, the Philippines and Thailand. “We’ve seen emerging markets small caps consistently outperform large caps; they have enjoyed good structural growth,” explains Derkash. The reasons are manifold: emerging markets small caps (companies with a market cap between $500m and $2bn) have been relatively insulated from the vagaries of the recent global downturn; much of their growth has been described by local markets, with some of the best performers in sectors such as pharmaceuticals and healthcare, Derkash points to Brazil as a useful template. Structural employment has fallen to less than 5%, “which means that employers are having to provide added value, such as dental insurance, to ensure they get the best workers. Some of our best picks have been in pharmaceutical firms and dental insurance companies and some of these have been growing at rates of 20% a year. These are the type of companies that benefit from structural growth.”

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

Even in the recent adverse headwinds facing a cross section of the emerging markets (particularly the Ukraine, Indonesia, Argentina and China, for instance), small caps have still outperformed large caps, adds Derkash, who views the current outflow of investment dollars as an entirely “normal and healthy correction.” Over the longer term Derkash expects that returning investors into emerging markets will become increasingly nuanced. ETFs and even some of the benchmark emerging markets indices, he concedes, look to be relatively blunt instruments. “Typically involving 750 or so stocks, a broad based emerging markets index will result in the top ten stocks making up 20% of a portfolio. When you manage against a heavily concentrated weighting of this kind, lots of managers feel the need to hold on to that stock as a risk position, even though those holding might not necessarily provide a good return. That’s one reason why, I suggest, we are seeing more sophisticated investors are now beginning to take a percentage of their emerging market allocation and giving it to more nuanced emerging markets funds and ultimately this is to the benefit of both markets and investors.” For now, macroeconomic developments dominate and reinforce some investors’ short-term preference for developed over emerging market,” Langridge explains. So what needs to happen for investors to shift allocations back to the emerging markets wholesale? According to Derkash: “Two things have to happen. We need to see more stable growth coming out of China and that growth rate needs to be in excess of 7%. We also need better visibility as to where US and/or global rates will settle over the near term and where those rates might peak.” He points out that valuations of emerging markets stocks are currently at a 30% discount to developed markets, a level at which, in the past, the markets have begun to see something of a rebound. I

IN THE MARKETS

THE CHALLENGE OF STABILISING INVESTOR INFLOWS

Turkey’s central bank governor Erdem Basci speaks during a press conference in Ankara on Tuesday, January 28th 2014. Basci signalled he was reversing course and raising interest rates to address higher inflation and a falling currency. Photograph by Emrah Gurel for AP; photograph supplied by pressassociationimages.com, February 2014.

TURKEY: ATTRACTING FOREIGN INVESTMENT IN UNCERTAIN TIMES Emerging markets have come under renewed pressure of late: not least Turkey, where the cost of sovereign ten year debt has risen to 10.45%, the highest for three years and where the central bank was forced to push up interest rates (raising all three main policy rates by between 425 and 550 basis points) to shore the lira at the end of January. Does the central bank move mark a watershed in Turkey’s outlook in 2014? Istanbulbased lawyer Mehmet Gün, founder and senior partner of Mehmet Gün & Partners, thinks so. He makes the case. URKEY IS A country of two halves. It is economic success story that has been strengthened by increased market liberalism, but at the same time, the government evinces a narrow, authoritarian polemic and the dramatic tension between these two trends has had its price. Clearly benefiting from the former, Turkey’s international economic relations remain buoyant. For example, Turkey’s post-liberalised economy has encouraged foreign trade resulting, for example, in an eleven-fold rise the

volume of exports between Turkey and the Middle East and a twelvefold rise in imports. Foreign trade with the Middle East and North Africa (MENA) region is now worth almost $60bn and, according to government projections leading up to the centennial of Turkish Republic in 2023, this figure is expected to rise to $200bn. To tighten cultural and economic ties Turkey is also enhancing its diplomatic ties in the MENA region. In the past five years, mutual trade and cooperation agreements in areas such as tax

and customs have been signed with numerous international states. It is all happening to good effect; foreign direct investment inflow from the MENA countries to Turkey last year was valued at $1.17bn out of a global figure of $10bn. In 2012, just over 30% of the 3,031 new companies with international capital established in Turkey had Middle Eastern shareholders. This is even higher than the percentage of companies with shareholders from the European Union and is a good indicator of the developing power of the Middle East in the Turkish economy. Further afield, the Turkish and Japanese governments have established a strategic partnership to rebuild northern Iraq. Back in 2003, construction activity by Turkish investors in the region was valued at a relatively modest $242m; today the value of capital goods project work has risen at least six-fold. Turkish companies are involved in house-building, infrastructure, educational, healthcare and defence projects and Iraq is now one of Turkey’s top five export destinations. Turkey also benefits from cultural links with countries in its hinterland. The most common language in the Northern Iraqi cities of Erbil and Kirkuk is Turkish, for instance: in part due to the long standing presence of thousands of Turkish investors and workers in the region that are involved in the carbon resources sector. Oil and gas is exported from Iraq to Turkey (and beyond) through a growing network of pipelines. This network also carries other benefits. Israel and Southern Cyprus, for example, now export their own output via the same pipelines.

Islamic finance The Turkish Capital Markets Board is working hard on formulating regulation that will facilitate demand for Islamic finance products in the country. With its robust growth, the country has caught the interest of the Arab investment community, particularly from the Gulf States. Investors have been drawn by the widening range of investment

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

products, from a debut sovereign sukuk issue last September to foreign currency denominated eurobonds from both banks and corporations. The market share of participation (or Shariah-compliant) banks, in the Middle East is also increasing in Turkey. According to recent statistics published by the Turkish Statistics Institute participation banks held 6% of banking sector assets in mid-2011, with nine Arabic banks holding shares in Turkish banks, eight of which are majority stakeholders. Construction of an International Financial Centre (IFC) is now under way in Istanbul, and the government aims to improve the economy by bringing new investment funds into the country, allowing Turkish businesses to obtain easier finance, and for the domestic insurance sector to become closer to international financial markets. As part of its commitment to legislative reform, and to improving the

business climate in Turkey, the Cabinet has sent legislation to Parliament for the formation of the Istanbul Arbitration Centre (IAC). Ankara wants the IAC to become a major dispute resolution centre for investors, particularly in the IFC, and a centre for the resolution of commercial disputes in the region. The Turkish deputy prime minister believes that Istanbul can fill the gap between the financial centres of London, Frankfurt and Dubai and become a regional powerhouse. Turkey’s strategic geographical position, its strong cultural links with the Middle East, its stable economic growth and a young, well-educated and highly-skilled workforce, make it an attractive option for both investors and refugees from political turmoil. Cairo has already lost some of its international standing to Istanbul, as was shown when the Nikkei Index of Japan relocated its Middle East offices to Turkey. There is no doubt that, following the Arab uprisings, Istanbul

benefited from its position as a strong, stable economy outside the EU, and from its safe haven status for investors in the Eastern Mediterranean, North Africa and Central Asia region.

Fluctuations in fund flows In the 1980s, Turkey undertook significant liberalisation of its national economy. Since then, it has increasingly become a pivotal part of the international economy. However, this global exposure has made Turkey vulnerable to international financial fluctuations. Like other emerging markets, Turkey’s financial markets can become volatile depending on the ebb and flow of international money in the financial markets. The US Federal Reserve’s recent decision to reduce purchase of government bonds resulted in the immediate fluctuation of the Turkish lira against the US dollar, euro and other hard currencies. The Turkish central bank responded quickly, raising interest rates to stem

TURKEY HOLDS ITS OWN IN EPFR REPORTED EMERGING MARKETS EQUITY FUNDS

oing into February, jittery emerging market investors continued to pull out of EPFR tracked emerging market equity funds, pulling out over $4bn over the two weeks to end January. Of this figure, just under half ($2bn) looked to be retail investors, who last committed money to the fund group in the early part of the second quarter last year. The data provider, which is a subsidiary of the Informa Group, reports that the outflow of retail funds out of emerging markets was the largest directional flow since August 2011. The winding down of the US Federal Reserve Bank’s quantitative easing program and continued worries about China’s economic growth

rates kept the pressure on emerging markets currencies, interest rates and growth prospects through January. Among fund groups geared to the Asian markets China Equity Funds saw their current inflow streak snapped as renminbidenominated flows turned negative for the first time in six weeks, says EPFR. Wondenominated commitments were at a six week high in early February high resulting in Korea Equity Funds posting their biggest inflow since late December. Funds dedicated to Thailand had a time however despite being one of the better performers, with redemptions the biggest in over a decade as voters in the

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

politically divided country headed to the polls, and outflows from India Equity Funds hit their highest level since the third quarter of 2011. Funds dedicated to Turkey on the other hand (another member of the so-called “fragile five”) continued to defy gravity despite the country’s creaking currency, persistent current account deficit and the corruption scandal that has ensnared the government. One reason cited for the seven straight weeks recorded by Turkey Equity Funds is the expectation that lower energy prices will relieve some of the pressure on the Turkey’s current account deficit, since the country imports over 80% of the oil it uses.

IN THE MARKETS

THE CHALLENGE OF STABILISING INVESTOR INFLOWS

Turkish riot police take cover as they fire water cannons and tear gas at hundreds of demonstrators who were trying to march to the city’s main Taksim Square in Istanbul, Turkey, Saturday, Feb. 8th 2014 in protest against legislation which critics say will tighten government controls over the Internet. Demonstrators hurled firecrackers and stones Saturday at police officers who cordoned off Taksim Square. Many of the protestors also denounced a corruption scandal involving former Cabinet ministers and called on the government to resign. Photograph by Emrah Gurel for AP; photograph supplied by pressassociationimages.com, February 2014.

the slide in the value of the lira. It intervention seems to have worked. Currency fluctuations effect the financial state of many businesses in Turkey as the economy is mostly based on imports denominated in hard currencies. No surprise then that the financial authorities have been keen to stem the inflows and outflows of hot money and currency fluctuations without compromising the country’s liberal foreign exchange regulations. On the other hand, in an effort to address the large trade deficit and to decrease the level of borrowings without considerably slowing down the economy, the Turkish lira has been deliberately allowed to depreciate against hard currencies in a controlled manner. The consequence is a marked decrease in the trade deficit through last year even while the Turkish lira continued to depreciate. Other elements, however, came into play and Turkey experienced currency fluctuations and a decline in stock market value relating (in part) to the Gezi protests in June 2013. A similar situation developed following corruption-related raids beginning on December 17th last year. In the event, the police raids on sus-

pects coincided with the US Federal Reserve Bank’s decision to reduce bond purchases, which exacerbated investor jitters. Deputy premier Ali Babacan noted at the time that currency depreciation was largely due to external reasons and not the issues relating to the corruption investigation; though the point is moot. These developments reaffirm the view that foreign direct investments in tangible business sectors, other than the financial markets, would be preferable over volatile financial investments. Investments that lead to increased industrial production and export capacity, involve the transfer of higher technology and research and development are encouraged and facilitated. A special bureau under the prime minister’s office, ISPAT, serves this purpose. Large scale investors receive development land almost free of charge in organised industrial zones and support from all government and local municipalities.

A better judicial process? Despite all these efforts foreign direct investment is not at satisfactory levels and in an effort to better understand the causes the management of

ISPAT sought the opinion of a number of Turkish law firms advising on international trade in Turkey. All the firms who attended the ISPAT meeting identified shortcomings in the justice system as the main hurdles to effective investment. Exploring and exploiting the country’s potential will not be possible until the country’s justice system and democracy is improved and stays abreast of economic developments. The Gezi Park protests in Istanbul demonstrated that Turkey’s democracy did not satisfy the elite of Turkish society. The protests also showed that a lack of timely judicial interference into civil disputes clearly contributed to civic unrest. The lack of effective protection for civil and individual rights, especially against the oppressive use of force, meant that a peaceful demonstration soon became unlawful. Moreover, the relocation of public prosecutors on duty over the period of unrest following the corruption raids resulted in an almost three week long delay in the conduct of ordinary matters in the public prosecutor’s offices. Uncertainty among members of the judiciary and bureaucracy over what is or might be policy is likely to cause further, incalculable damage to the justice system. The public at large remains concerned and expects justice to be done to those caught with direct evidence of suspicious corrupt practices. Obstacles in the way of solving Turkey’s major problems, and the country becoming a first class democracy, are mostly due to not having a first class impartial justice system operating independently of the state. This is caused by a lack of accountability in the ruling elite; the judiciary and the state are regarded as quite literally unimpeachable. Turkey’s true potential can be realised by eliminating limitations and restrictions preventing or hindering the judiciary’s independent functioning. However, first the members of the judiciary and the judicial system need to move towards full accountability. I

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

THE PERILS OF FORECASTING

Given the recent unravelling of the US Federal Reserve Bank’s and Bank of England’s forward guidance policies as a result of incorrect unemployment forecasts, Jens Vanbrabant, lead portfolio manager at ECM Asset Management (an independently operated credit investor owned by Wells Fargo) looks at the role of forecasters and how they go about studying credit spreads and government bond yields.

TRACKING TRACK RECORDS HEN JANET YELLEN and Mark Carney accepted their new jobs at the US Federal Reserve and the Bank of England, they were fully aware of the poor forecasting track record of their central banks’ research departments. And yet, in midFebruary both found themselves on the back foot trying to explain to financial markets the unravelling of carefully crafted forward guidance policies as a result of incorrect unemployment rate forecasts. Despite the very best intentions, the Bank of England’s and Fed’s forecasts gave their leaders exactly what they wanted to avoid: speculation about imminent rate rises. It was not just the world’s leading central banks that were on the defensive. In the aftermath the OECD admitted that its repeatedly false assumption that governments would take effective steps to ease the eurozone crisis caused it to make overly optimistic growth forecasts for the region’s economies. Over 2,500 years ago, the famous Chinese philosopher Lao Tzu stated: “Those who have knowledge, don’t

predict. Those who predict, don’t have knowledge”. So why do people persist in making mental and mathematical models that are ultimately incapable of identifying those features of the past that will be replicated in the future? Recently, weather forecasts have become much more accurate thanks to modern technology, but why has there been no similar improvement in economic forecasts? The answer may be that there are simply too many aspects of economic behaviour that behave randomly and that cannot be modelled. Is there any point in forecasting? Absolutely. In the absence of a crystal ball, it is the least bad alternative at our disposal to deal with the future. Making predictions allows difficult decisions to be made by providing a (often false) sense of security. What then constitutes “best practice”in terms of forecasting? When we look at the thoughts of some of the world’s most reputable investors, a few basic principles stand out clearly. The founders of value investing, Benjamin Graham and David Dodd, insist that a margin of safety be

built in into every investment decision. Whilst a margin of safety doesn’t guarantee a successful decision or investment, it does provide room for error in a forecast. Warren Buffett adopted the same idea as a key tenet of his investment philosophy by coining the term “wide moat” and by insisting on only buying companies with distinct competitive advantages over other firms in their industries.

Mental bias Nassim Nicholas Taleb, author of the excellent book Antifragile offers another insight. He points out a mental bias that makes us notice change, not statics. We notice what varies and changes more than what plays a large role but doesn’t change. As such, when asked to forecast what the world would look like in 25 years, Taleb uses the notion that most technologies that are now 25 years old should be around in another 25 years. The classical role of the forecaster therefore, is not to look into the future but to analyse the present and suggest sensible actions. As William Osler stated: “The task of man is not to

Credit spreads across various assets within a historic range ASSET CLASS MEZZ ABS SENIOR ABS HIGH YIELD T1 LT2 SENIOR BANKS COVERED BONDS INSURANCE CORPORATES EMEA

30.09.13 OAS spread

1st decile

2nd decile

3rd decile

4th decile

5th decile

6th decile

7th decile

8th decile

9th decile

10th decile

297 72 467 373 281 122 105 260 128 297

40 10 236 142 0 20 0 50 50 128

49 20 297 97 40 27 20 60 58 140

50 20 350 104 46 27 20 64 60 155

134 24 399 172 69 39 24 90 84 229

318 76 459 425 224 105 74 240 118 283

409 110 516 523 288 120 98 278 120 310

516 156 593 618 315 134 126 319 130 358

636 192 658 766 359 158 155 392 145 396

976 257 761 1008 493 198 178 513 172 456

1493 505 1402 1493 641 250 212 749 267 933

Source: ECM, February 2014.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

IN THE MARKETS

THE PERILS OF FORECASTING

History of the US ten year interest rate 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Dec 1, Jan 1, Feb 1, Mar 1, Apr 1, May 1, Jun 1, Jul 1, Aug 1, Sep 1, Oct 1, Nov 1, Dec 1, Jan 1, Feb 1, Mar 1, Apr 1, May 1, Jun 1, Jun 29, 1877 1885 1892 1899 1906 1913 1920 1927 1934 1941 1948 1955 1962 1970 1977 1984 1991 1998 2005 2012

Source: ECM, February 2014.

see what lies dimly in the distance, but to do what lies clearly at hand.”The job of pure prediction on the other hand is associated with seers, astrologers and other people involved in divination.

When ECM set the 2014 target returns for its funds in the fourth quarter of last year, we looked at where credit spreads and government bond yields were trading within their

15 year historic range. Our analysis found that credit spreads predominantly traded within the fifth to sixth decile (with the first decile being expensive and the tenth decile cheap). The table highlights the spread at which credit asset classes were trading at the time of our return setting exercise and into which decile each credit asset class fell. The table shows that whilst not overly cheap, credit spreads were by no means expensive. Government bond yields on the other hand were trading close to the tightest levels observed not just in the last 15 years but over multi-century periods. Armed with the above knowledge and the fact that credit spreads on balance tend to be negatively correlated with GDP growth and with interest rate movements, constructing our portfolios from a duration hedged starting point therefore was eminently sensible. I

WILL INDIA’S GENERAL ELECTION HELP THE EQUITIES MARKET?

ith a general election on the horizon India is under close scrutiny from investors. India was one of the hardest hit emerging markets last year. Its currency slumped to a record low and sluggish economic performance coupled with a lack of structural reform and corruption, made the country an unappealing market. To turn things around the government introduced indirect tax cuts and a new head of the central bank, Raghuram Rajan. However, all eyes are now on the outcome of the general election to see if this platform can be built upon and if India can once again provide a worthwhile opportunity for investors”, according to Edward Bland, head of investment at Duncan Lawrie Private Bank, says “Whatever the outcome of the election, whoever takes the helm will benefit from a marginally improving economic situation. Rajan hiked interest rates and appears to have had some success, bringing inflation down below 10%. Many foreign investments are being held back as investors sit on the fence waiting for a new government to be formed. The election will remove political uncertainty and provide a boost to economic growth.” According to Bland, the incumbent Congress Party is unlikely to retain power as its track record in recent years has been poor. “Although they introduced food subsidies, which have been an excellent way of lifting

vast numbers of the population out of poverty, this has left the government with a high subsidy bill and diminishing means to meet it. Supply side reform is now essential. Looking stronger in the polls is the Bharatiya Janata Party (BJP).” Led by Narendra Modi, a win for the BJP would see an increase in business investment and the implementation of a growth-oriented programme of reforms adds Bland. Former governor of Gujarat, Modi has a reputation for implementing economic reform, and has succeeded in driving a growth rate in excess of the national average (10% per annum) between 2006 and 2012. “The equity market has already moved, possibly discounting a Modi victory and the dislodging of the Congress Party. Excluding the move in the rupee, the market is up 4.5% over the past 12 months, versus a drop of 3.2% for broader emerging markets. There is more to play for. We believe in the longer-term potential of the Indian economy and stock market beyond the election and see it as being one of the more attractive emerging markets for investors. The key thing is that after the Indian election, stability returns to the country quickly and action is taken to help drive growth in the economy. Since 2010, political reform has not matched early progress, so the election could be a turning point for the economy and in turn the opportunities for investors," holds Bland.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

Fear and loathing on the regulatory trail NVARIABLY, INCOMING REGULATION requires a renewed commitment to compliance and, in some cases, substantial internal organisational shifts. Just how substantive these shifts are is highlighted in The Regulatory Pressure Cooker: Assessing Regulatory Stress in the Financial Services Sector survey, commissioned by SunGard and conducted by Longitude Research in late 2013. Some 400 senior financial services executives were polled across the globe and the headline finding is that many of them do not “feel ready for the changes taking effect this year. Only one in two companies say they are highly ready for the regulatory change that they must confront over the next two years. Readiness ratings are even lower in areas such as staffing and budgets”. In a summary of the survey findings Jeffrey Wallis, managing partner and president of SunGard Consulting Services explains, “The definition of what regulators are becoming concerned about is broadening to include areas such as operational risk, adding extra strain to the financial services industry. Executives at the highest levels are struggling to marry ensuring regulatory readiness with maintaining a focus on day-to-day operations. In our work with firms on regulatory compliance, we see the most success when a business takes a combined

approach to the twin challenges of growth and compliance,” Not only that: almost half of survey respondents describe themselves as highly stressed by the current regulatory pressure. This rises to three-quarters if including those who are moderately stressed.” In the short term respondents do not expect any let up, with three quarters of respondents saying they believe they will remain highly or moderately stressed in two years’ time. There are other repercussions too. According to respondents, dealing with regulatory requirements is demanding attention at all levels of the business, potentially disrupting performance. One in two respondents warns that dealing with regulatory change has distracted his or her firm from core business activities, which may have damaged shareholder returns and companies’ ability to invest for the future. This pressure extends to the highest levels of the business: half of all respondents say their companies’ chief executives are highly stressed by these issues. Despite the gloom; there is some upside. Survey respondents concede there are some benefits to organisational change. The broad nature of regulatory change is driving a more cross-functional response within businesses. Best-in-class institutions are breaking through siloes, allowing

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

REGULATION IS STRESSFUL AND SLOWS GROWTH

Regulatory change is second only to market volatility as an executive issue for financial services firms, according to a new SunGard survey. With many new regulations taking effect during the course of this year, in some cases it is even considered the number one strategic risk. Senior executives are, says the survey, now concerned that regulatory change is distracting attention from core business activities and potentially hindering the ability of companies to grow.

for a more efficient response to business issues. Moreover, firms are now looking at a new round of investment which though heavily biased towards compliance and technology should ensure that over the medium term they are well prepared to cope with most eventualities. Investment on this scale means that businesses will be encouraged to rethink the way they work. That level of change will not occur without pain. The survey shows that banks, for instance, are increasingly required to move beyond a tick box approach to compliance to a culture where awareness of regulatory requirements is ingrained across the institution. “Financial services businesses understand the need for cultural change, but are struggling to achieve it,” concedes the survey. Some 40% of respondents says are finding this cultural shift challenging. Given these stresses and pressures, it is not surprising that more than a third of companies believe that the regulatory response to the financial crisis has been overblown and that changes are being made too quickly. However, in most cases, they are getting on with their response to regulatory change rather than trying to rein in or rescind reforms. According to Sang Lee, managing partner, Aïte Group,“Regulatory reform is putting the financial services industry under intense pressure, and the situation will not change in the near future. This pressure is being felt all the way up to the C-suite and the board. Regulatory uncertainty has forced some companies to put off key investments in new industries and geographies at a time when they are increasing their investment in compliance across departments. Regulations may be putting a strain on the industry, but we are starting to see some companies use them as an opportunity to reorganise themselves along more efficient lines. These businesses will be the future leaders in the industry.” I

SPOTLIGHT

INVESTORS OPT FOR REAL ASSETS

Photograph © Fantasista/ Dreamstime.com, supplied February 2014.

Investors look to real assets One in five in short study survey say rise in exposure to real assets will be significant SHORT STUDY of 54 ‘institutional investors’ by alternative asset manager Aquila Capital claims that half of the respondents expect to see a significant increase in allocation to real assets; already 44% of the survey respondents claim to have more than 10% exposure to real assets. Some 7% of respondents expect their exposure to the segment will be reduced. Unsurprisingly, given the surge in property prices in the main capitals of Europe and the resurgence of a large slug of commercial property, real estate is ranked as the leading ‘real asset’ offering the best investment opportunities by investors, followed by infrastructure (18%); commodities (15%); farmland (15%) and renewable energy (15%). Aquila’s study identifies the key drivers behind this apparent appetite for real assets; though frankly the study base is very small. Key drivers include long-term positive cashflows (56%); protection against inflation (56%); portfolio diversification thanks to modest correlation with other asset classes (42%); continued need for attractive risk/returns profile (27%); and growing familiarity with the asset class due to existing allocations (17%). Other considerations that look to support the case for real assets over the long term include a fast growing global population (55%), increasing standards

of living, especially in emerging markets (51%); out of date infrastructure in need of modernisation (50%); increasing industrialisation and urbanisation (44%); and long term supply/demand imbalance (41%). Aquila’s findings are echoed by Towers Watson’s latest Global Pensions Asset Study, which reports an increase in exposure to alternatives generally from 5% to 18% of portfolios over the 12 months to the end of 2013.

The steady return of European structured products Investment certificates turnover and leveraged products on European exchanges on the rise in Q4 2013 S THE EUROPEAN structured product market set for a comeback? Certainly trading volume of structured products on European exchanges looked to have gained 10.3%, with trading volume valued at €26.7bn in the last quarter of 2013, compared with quarter three (Q3). Meanwhile, year on year, European exchange turnover was up 17.9%, according to the latest analysis by Derivative Partners Research on data collected by the European Structured Investment Products Association

(EUSIPA) from its members. The turnover data of the Dutch market provided by the Netherlands Structured Investment Products Association (NEDSIPA) were also included in the statistics for the first time. Between October and December 2013 the exchanges of member countries with investment products transacted €11.2bn, a rise of 11.2% in comparison with the same period in 2012. Investment certificates accounted for 41.9% of the trading volume on exchanges in EUSIPA-member countries at the end of December. Leverage products recorded active trading, with volume in products such as warrants and knock-out securities substantially up (by 23.3%) to €15.5bn in comparison with the last quarter 2012. Turnover in leverage products accounted for 58.1% of the total turnover. The range of products offered on the exchanges of EUSIPA member countries (Austria, France, Germany, Italy, Netherlands, Sweden and Switzerland) at the end of Q4 comprised 471,608 investment certificates and 649,498 leverage products. The total of the listed products offered grew by 2.8% in comparison with the third quarter of 2013. The number of investment certificates listed was up 12.2% in comparison with the same quarter of 2012, and the number of leverage products was up by 15.2%. In Q4 2013, banks launched 582,512 new investment certificates and leverage products. The number of new issues of structured securities was thereby up 5.9% on a quarter by quarter basis. Leverage products accounted for 425.683, or 73.1%, of the new issues. Investment products accounted for 156,829, or 26.9%. The market volume— or open interest—in Austria, Germany and Switzerland at the end of 2013 was €248.1bn. The total numbers are influenced by a statistical effect due to the Swiss National Bank having, as of Q4 2013, enlarged their reporting basis. Broad trends can thus be rebased to Q1 2014. Single country changes other than in the Swiss market can be taken from the European statistics.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

NAPF stewardship disclosure framework takes shape

Photograph © Silvionka/Dreamstime.com, supplied February 2014.

51 asset managers have signed up to greater operational transparency OME 51 FIRMS with nearly £10.5trn of assets under management have completed the UK’s National Association of Pension Funds’ (NAPF’s) Stewardship Disclosure Framework, which was launched back in October last year. Signatories have responded to the UK’s NAPF’s call for greater transparency and each has completed the implementation of a disclosure framework for their firm. A further six firms have committed to completing the framework by the end of March. While a large number of fund managers have signed up to the stewardship code many have yet to rise to the challenge set by the NAPF’s framework of making their stewardship activities more transparent to current and prospective pension fund clients. The objective of the code is to facilitate better engagement between organisations and shareholders to help improve governance and long-term returns. It is primarily directed at investment managers who act on behalf of asset owners, but asset owners, such as pension funds, are also strongly encouraged by the FRC to report if and how they have complied with the code’s principles.

According to Joanne Segars, chief executive, NAPF, “A number of signatories of the stewardship code have yet to complete a framework. Inevitably, this raises questions about their willingness to give transparency in this crucial area. With pension schemes like those sponsored by BT, Barclays, British Airways, Marks & Spencer, Nationwide and Whitbread having signed up to the Stewardship Code it is hard to imagine why an asset manager would not want to disclose their stewardship credentials to existing and future clients.” Asset management firms that have completed the framework include Lazard Asset Management and Legal & General Investment Managers. Meantime, Allianz Global Investors, Ashmore Investment Management and Franklin Templeton Investments have committed to completing the framework by the end of Q1.

European high yield issuance at four-year high CMDPortal says total issuance in Jan and Feb reached €11bn SSUANCE OF EUROPEAN high yield corporate bonds is at a four year high according to new figures released by global data network CMDPortal. Not many people were putting any bond asset class at the top of their performance charts for 2014; particularly in Europe where the general consensus is that the region is at least 18 months behind the United States on the credit curve. In that regard, the European credit market has been at a crossroads in recent years. Emerging markets meanwhile remain in the bubble and crunch phase. However, this year the signs are that European corporations are firmly re-leveraging (good too perhaps longer term for other parts of the financial and invest-

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

ment markets as some of this money goes into mergers and acquisitions and buyouts). High-yield bond fund managers say they expect many of the same factors that fuelled the market last year to be the focus this year, notably economic recovery, interest rate markets, low corporate default rates and new issues. The US interest rate market was an important driver of high-yield corporate bonds last year, very likely any movements in the dollar interest rate will continue to be a focal point for bond investors through this year. Moreover, low corporate default rates continue to help drive the performance of the high-yield market, along with the return of growth, zero interest rates for the past five years and investors’ hunt for yield. In 2013 total European high yield issuance reached €64.3bn, the highest in four years. In the first two months of 2013, total issuance was higher at €15bn. Some of this reduction is accounted for by a 6% drop in redemptions of European high yield maturing bonds, says CMDPortal. The European central bank’s forward guidance and accommodative profile has kept borrowing costs low, making bond market financing with longer duration deals more attractive, adds the firm. One of the key attractions remains the availability of long duration funds, compared to what is available in loan markets. This is particularly true in USD issuance, which increased by 6.5% year on year. Good examples include, INEOS Group Holdings’ $590m and Stena AB’s $350m ten year bonds. Large prints in euro includes ThyssenKrupp AG’s €1.25bn five year bonds. The 3.125% notes were priced at a discount of 99.201 with a spread of MS+215bps. Meantime, Telecom Italia printed—after the group was downgraded—€1bn in seven year bonds. The 4.5% notes were priced at a discount of 99.447 with a spread of MS+300bps. High yield issuers are also finding demand in sterling. Jaguar Land Rover, for example, printed £400m eight year bonds. I

THE BEAR VIEW

GROWTH, CARNEY’S CONUNDRUM

Bank of England governor Mark Carney will be aware that a ‘one-off’ wealth transfer from investment and pension funds into what is effectively the cash economy will not continue much beyond 2014. Moreover, quantitative easing (and with it cheap liquidity) is probably on the way out as well. The fear that the UK will slip back into a slow growth, zero inflation scenario should be a very real concern. Simon Denham, chief executive of Skrem Ltd, takes the bear view.

The hunt for real growth T HAS BEEN claimed, with some reasonable authority, that UK growth is heavily geared toward consumer spending. The argument is that the growth is bought ‘on-tic’ and that the UK is simply building up yet another problem for the future. On the other hand, overall growth seems rather more widespread. The Bank of England and the Treasury are tilting toward the belief that, finally, a corner has been turned and the good ship UK is set for a reasonably fair course into 2015 and beyond. GDP growth through 2013 exceeded expectations to a startling degree but within this number was that Q4 actually slowed marginally from Q3 and Q2. A fact that is difficult to square if you believe in an accelerating recovery story. GDP for 2013 was up 2.8%. A nice enough number but hardly up there with previous recovery trends. In fact it is almost bang on the ‘average’ for the last sixty years i.e. a mid-curve number rather than a resurgent one. Consumer spending for 2012 averaged about £242bn per quarter and this increased to approximately £248bn/Q in 2013 with Q4 2013 showing growth of almost 5.5% year on year. This has led to upgrades in GDP numbers throughout the year to reflect huge strength in consumption expenditure. This is odd because, apparently, average income has stagnated over the last few years with just 0.7% recorded for 2013. So where is all the extra money coming from? Consumer lending is the obvious and easy answer. Bank of England numbers show (surprise, surprise) that lending rallied by a corresponding 5.8% annualised to the end of Q3.

Simon Denham, chief executive officer of independent City consultant Skrem Ltd.

However, lending for consumer goods is, curiously enough, quite small in comparison to the overall spending total. Increased lending will have delivered possibly 1% of the 5.5% increase. Clearly then, the slack has been taken up elsewhere. Some can be explained away by the growing workforce. Unemployment is falling but, even if it were not, the actual numbers of people in employment will go up anyway as the population increases. Some of the spending growth could be explained by the release of housing equity. Even so, re-mortgages are still hovering below 40,000 a month, numbers that have hardly budged from the worst levels of 2009 and miles down from the 100,000 a month before the crisis. This is not evidence of a population rushing headlong into

penury. And, for all of their gruesome headlines, payday loans are miniscule by comparison What seems to have been ignored over the past few years have been the vast sums that have been ‘awarded’ over the PPI miss-selling scandals. The totals now set aside by the various lenders has now passed £20bn. The vast majority of this will have been handed out to those least likely to save it. Unfortunately it is rather a truism that PPI was focused almost entirely on the lowest earning stratum of the UK, any financial awards will be seen as something of a windfall by their recipients and, as such, as free money to be spent or, indeed, as cash to be deposited on a new car. The average sums awarded appear to be around the £2,250 mark, not life changing but, almost certainly, temporarily economic data changing. This money is tax free and represents an average one-off 10% pay rise to the recipients. To what extent will this have impacted the 5.5% surge in consumer spending through 2013 is hard to estimate but is almost certainly significant. Elsewhere the story of weak growth is broadly the same. Because of it, the central banks of Europe and the US are unlikely to risk higher rates until well into 2016/2017. Across the globe growth is hard to grasp with Brazil (one of the ‘fast growth’ emerging markets) at just 2.2% YOY but this hides a 0.5% contraction in the last quarter. While the markets are unlikely to get into ‘happy mode’ in the near term it is also true to speculate that any kind of crash is equally implausible. With interest rates marooned below 1% the best yields remain within the equity market albeit not quite so juicy as before. I

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

REAL ESTATE

BRICKS RETAIN KERB APPEAL AMONG CLICKS With shoppers defecting to online, store requirements could plummet by a quarter in the next five years, compounded by living standards remaining stubbornly stuck at standstill across most of Europe. Against that backdrop, why are shopping centre investment volumes far above those of 12 months previously? The reality is that the European retail investment market is deeply polarised (by type, scale, significance and geography) and that investors still have a taste for retail-led destinations, which in turn are embracing leisure and digital in a bid to stay relevant, says Mark Faithfull. NY LAST PRETENCE that shoppers would never defect online because of their love of meeting places, the sociability of shopping and the familiarity of their favourite high streets has vanished. Among Europeans, UK shoppers love online the most, as evidenced by their insatiable spending shift, but Germany, France, Europe’s north and East are all seeing significant buying shifts towards e-commerce. On top of that, the best retail operators are crossing borders not with stores but with online-derived delivery, providing their wares online for multiple countries and, increasingly, from indigenous language websites.

Consumers are also interacting with the multiple channels available in an ad hoc manner. That may mean researching products in bricks-and-mortar retail stores before purchasing online, using click-and-collect, ‘showrooming’, and increasingly using mobile devices to do it all on. Such trends add up to some impressive numbers. Forrester predicts that European online retail sales will reach €191bn by 2017, up from €112bn in 2012—reflecting an 11% compound annual growth rate over the five year period. US online retail sales will hit $370bn by 2017, up from $231bn in 2012.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

INVESTMENT IN MALLS STILL STRONG

Photograph © nMedia/ Dreamstime.com, supplied February 2014.

The UK retail market remains the most advanced in Europe in terms of omni-channel retail [omni- and multiare often used interchangeably but the former is supposed to represent a seamless, fluid version of the latter] and not all markets are made the same. France continues to pioneer a Drive (click and collect) format for grocery retail, which has influenced retail globally, while many German retailers came to online quite late but are investing heavily in a bid to catch up. Germany is Europe’s second biggest e-commerce market. By contrast, penetration of e-commerce remains lower in southern Europe, notably the major retail markets of Spain, Italy and Portugal, primarily because of a lack of broadband infrastructure, which has resulted in Poland and the Czech Republic moving ahead of the Mediterranean markets in online availability. Not surprisingly, such profound change has been occupying the minds of retail landlords across the continent and while strategies and opinions divide on the issue, there is a consensus that e-commerce means less traditional shops. Quite how deeply that reduction will bite is the big question but Robin Bevan, head of locations at UK-based Javelin Group, puts it at around 25% of the total stock.“Talking to retail CEOs, we think even that figure is conservative,” he says. Yet despite these apocalyptic warnings, research by DTZ reveals that European commercial real estate investment activity reached €46bn in Q4 2013, the highest quarterly volume since 2007. This took total investment volumes for the full year 2013 to €139bn, up by 17% compared with 2012 (€118bn). The year-end rush mainly benefited the retail sector, with volumes totalling €12.3bn in Q4, up 74% from €7bn recorded in Q3. Lead by strong volumes in the UK (€3.3bn) and Germany (€3.8bn), the retail sector has also registered more activity in France (€1.3bn) and in Italy (€1bn). Crossborder funds have mostly targeted

REAL ESTATE

INVESTMENT IN MALLS STILL STRONG

shopping centres and retail parks. “Non-European investors are clearly returning to the region and are now active in a wider range of asset types and countries,” says DTZ head of EMEA research, Magali Marton. “Growing institutional and sovereign capital, in particular from Asia, showed strong appetite for the European market. In this context, we confirmed our forecasts with an 8% growth anticipated in 2014 to €150bn.”

Retailer needs “The investment market generally is starting to pick up and for retail this will be a telling time, because during the rise of e-commerce there has not been much interest in property anyway. Occupation levels now will be much more reflective of retailer needs, not of austerity,” says Alice Breheny, head of research, property, Henderson Global Investors. “Investors will have to look beyond super-prime, because pricing is very keen already and that will only get more pronounced. I think the market is probably a fair bit safer than many investors perceive, so while the focus is currently on the top 20 centres in the major markets, this should really be expanded to the next 20-100. Beyond those centres, I can’t see why anyone would touch anything else.” She adds: “Some territories will become more appealing, again because of the search for value, which will almost certainly see Southern Europe come back, notably Spain and Italy. Italy’s fundamentals are not that bad although Spain is probably seen as more transparent. Spain’s better centres are attractive, as are high streets in high tourist locations such as Barcelona and Madrid, but it is also a more volatile market than Italy.” What shopping centre buyers and owners need to get a handle on is the likely future impact of e-commerce on investments says Florencio Beccar, fund manager for CBRE Global Investors European Shopping Centre Fund. Late last year he led research in the growth in omni-channel retail for the Nether-

Development giants Westfield and Unibail-Rodamco have both hived off their innovation into ‘Labs’. In January, Westfield London launched what it claimed as a European first with a clickand-collect hub in partnership with specialist Collect+. This will allow shoppers to pick up their online orders from the centre and Westfield London. Photograph kindly supplied by UnibailRodamco/Mark Faithfull, February 2014.

lands-based investor. The company is now assessing its own portfolio using an e-commerce Rental Impact Simulator [e-RISC] tool, developed as a result of the research and which assesses both online and practical risks for shopping centres. “E-commerce is certainly not the end for traditional retail and it is far from doom and gloom but this process has been crucial in enabling us to understand how best to optimise our portfolio,” says Beccar. Dutch developer/landlord Corio is another of those going through a major realignment, recently selling off a dozen smaller schemes and taking a 27% hit on their book value as of June 30th 2013. Corio set out is grand strategy at the start of December 2012, when it pledged to a full focus on its Favourite Meeting Places (FMP) portfolio, with an avowed intent to increase the quality of its portfolio and accelerate income growth. To do that has meant a reduction of its traditional retail centres (TRCs), reducing leverage and recycling capital. Chief executive Gerard Groener says of the strategy:“Corio sees the need to adapt to the changing retail environ-

ment and regards further specialisation as key. We have undertaken a thorough review of our portfolio and based on this review, we have identified assets that qualify as FMPs or will be able to adapt to the FMP concept. This further specialisation will consequently lead to the disposal of the remaining assets.” Germany’s largest landlord, ECE, has created two“interactive shopping experiences” at Alstertal-Einkaufszentrum, Hamburg and Limbecker Platz, Essen to pilot new ideas after a study by ECE and Roland Berger Strategy Consultants analysing the purchasing behaviour of around 42,000 consumers. “Developments that are well received by the customers will be continued and implemented in other centres. Ideas that don’t appeal to the customers will be replaced by new ones,” says Henrie Kötter, managing director of centre management at ECE.“We asked ourselves: what can we learn from online retailers?” ECE’s two ‘Future Labs’ are testing an exhaustive list of services, including a free app with a points and voucher system; a mega-screen Mall Wall; virtual kids’ adventure The Giants’ Journey; a 3D

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

guiding system Your Way2go and an Info Gate service where staff answer visitors’ questions via live video stream. Virtual mall avatar Gloria is also on hand to communicate via a touch-screen. Ross McCall, head of retail commercialisation at adviser Cushman & Wakefield, adds that there is a twospeed market for new and existing shopping centres. “In the newer malls we are seeing the best of that digital integration. What’s fascinating is the existing stock and how technology can be effectively implemented within those centres,”he says.“There is also the issue of how new digital activity is funded, marketing or asset management.”

Click and collect Development giants Westfield and Unibail-Rodamco have both hived off their innovation into ‘Labs’. In January, Westfield London launched what it claimed as a European first with a click-and-collect hub in partnership with specialist Collect+. This will allow shoppers to pick up their online orders from the centre and Westfield London is promising to provide a “luxury collection experience” with a premium lounge, complete with fitting rooms. The service offers shoppers the same opening hours as the centre as well as one hour free parking to collect their deliveries in a dedicated car parking zone. “The Collect+ @ Westfield pilot is part of our broader strategy to deliver digital solutions that enhance the customer shopping experience and drive sales opportunities for our retailers,” says Westfield UK & Europe marketing director Myf Ryan. For UnibailRodamco, much of the current work is focused on leisure, notably the Dining Experience, plus enhanced hospitality— such as concierge-style services rather than information points and a hotelstyle rating for its top malls. In part this reflects the company’s belief that traditional retail demand will diminish and need to be replaced by other functions. As recently as five years ago, many European landlords believed that no

ECE’s two ‘Future Labs’ are testing an exhaustive list of services, including a free app with a points and voucher system; a mega-screen Mall Wall; virtual kids’ adventure The Giants’ Journey; a 3D guiding system Your Way2go and an Info Gate service where staff answer visitors’ questions via live video stream. Virtual mall avatar Gloria is also on hand to communicate via a touchscreen. Photograph kindly supplied by ECE/Mark Faithfull, February 2014.

more than 5%-6% of mall space should be dedicated to food. Recent projects Westfield Stratford City and Trinity Leeds sit closer to 18%; Unibail-Rodmaco is looking to achieve around 12% and it far from inconceivable that European malls will eventually match the circa 25% dedicated to food and beverage in Asian shopping centres. Meanwhile, UK/French developer Hammerson, which is opening Les Terrasses du Port in Marseille in early May, is also looking at converging its malls with digital technologies. Retail portfolio director Peter Cooper adds: “We have launched a trial app, looking to connect tenants around a central hub. The key is to make it easy for people to browse but also to try and retain some control and to try and connect online time with store time.” Quite how the contemporary use of shopping centres will eventually pan out remains difficult to predict with any accuracy. Much is dependent on the retail tenants and even the most omnichannel sophisticated of those admits that they do not have all the answers. What does seem clear is that dominant centres in large and/or affluent markets

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

will continue to be attractive investments and that leisure and the convergence of digital and physical functions will become increasingly important. Given the race to own dominant and prime schemes, a reappraisal of the better end of the secondary market also seems inevitable in 2014. “For investors the other aspect is total redevelopment of failing locations, so perhaps a retail park that is on the edge of a town could be rethought as a hybrid, accessible centre offering convenience, click-and-collect, distribution and a small shopping centre,” reflects Breheny. “It’s hard to know exactly what that new type of scheme would look like but I think some new formats will emerge.” Indeed, perhaps the term shopping centre will become a misnomer—the thriving malls of tomorrow are more likely to be retail-led, mixed-use commercial and leisure destinations, as different from the malls of today as enclosed shopping centres are from Europe’s post-war high street parades. Such possibilities are buoying the market but the shape of the future remains elusive to even those at the leading-edge. I

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REAL ESTATE

All the REIT moves? For several years US REIT performance soared while all around them floundered but in May 2013 intimations that quantitative easing was to taper and that a rate rise might eventually be implemented knocked that progress off course. A sharp price correction followed and opinions are divided as to whether America’s real estate investment trusts have run out of steam in a more buoyant economy or whether the market just doesn’t get it. Mark Faithfull looks at what the opposing viewpoints mean for the coming year. O MOVED HAS the National Association of Real Estate Investment Trusts (NAREIT) been on the topic of the slide in REIT values that late last year it took to producing a tome called Urban Legend: The Myth of REIT Interest Rate Sensitivity, released to refute an overriding truism that the sharp decline in REIT stock prices over the latter half of 2013 was down to prospective rising interest rates and to counter that instead it has

largely been because of misperceptions by investors. REIT stocks have lagged the broader stock market since May, when fairly mild and detail lacking statements by the Federal Reserve prompted yields on Treasury bonds, along with other interest rates, to rise. The traditional view is that real-estate stocks perform in a similar fashion to bonds, which tend to experience price declines when interest rates rise. Ironically, given that

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

HAVE REITs BEEN DERAILED BY TAPERING?

Photograph © Marish/Dreamstime.com, supplied February 2014

REITs are invested across the property spectrum, improvements in the macroand property-economy bolster the fundamentals—such as occupancy, rental returns, yield compression – yet make REITs a less-well considered investment class. “The main story of 2013 was about recovery in the macro economy,” says Brad Case, senior vice president, research and industry information, NAREIT. “It is a slow recovery but it’s translated across the property market and it should mean an upturn in occupancy, rental income and confidence in all sectors.” Yet in many ways NAREIT’s report rekindled the core debate about the nature of REITs and why they have performed so dismally since May and, more importantly, what lies ahead in 2014 if interest rates continue to rise. In terms of fund raising, 2013 was a strong year. Listed and non-listed US equity REITs raised a total of $84.13 billion from investors—including $18.65 billion by non-traded investment trusts, nearly double the amount of capital raised by non-listed trusts in 2012. This fuelled a 12% increase in overall fundraising for equity REITs over 2012 levels. Fundraising for the year by publicly traded REITs remained essentially unchanged, totalling $65.48 billion in 2013, compared with $65.75 billion raised in 2012. Also, in terms of overall market capitalisation, listed REITs continued to grow in 2013 to $670 billion, up from $603 billion at the end of 2012, while the number of companies in the FTSE NAREIT All REITs Index rose from 172 companies at the end of 2012 to 203 by the end of last year. One school of thought is that REITs are a hybrid between fixed income and equities that behave at times like regular stocks and at other times like bonds. The jump in interest rates—and the consequent bear market in bonds—that began in May was the primary reason that REITs have under-performed the rest of the market and historically when rates spike, REITs fare poorly.

REAL ESTATE

HAVE REITs BEEN DERAILED BY TAPERING?

Yet that truism is refuted by Michael Grupe, an economist with NAREIT, who calls it an “urban myth”. He says instead that there are other factors at play and reflects:“REITs are clearly not [bonds]. A lot of investors may look at them that way, and make decisions based on that, but it doesn’t mean they’re right.” The plunge in REIT values lasted all summer, while the rest of the stock market climbed steadily on news of slow but steady economic recovery. By the end of the year, the S&P 500 index had posted an annual total return of 32.4%, while REITs had returned a flat 2.8%, despite being up by circa 18% before the Fed’s announcement. NAREIT points out that REITs have out-performed the S&P 500 for 16 of the past 24 years and are stable incomeproducers as they pay out at least 90% of their income in dividends, and in return pay no tax on that income. But these high dividends are a double-edged sword – because just as investors seeking high-yielding securi-

ties flock to REITs in times of low interest rates, some favour other high-yielding securities when interest rates begin to rise. In addition, a rise interest rates means capital debt repayment increases. However, Mark Marasciullo, New York-based managing director with adviser Jones Lang LaSalle, believes that there has been a “knee-jerk reaction” because of investors focusing on long term trends, not considering the current situation. “In a normal investment cycle, property would be in a late innings right now,” he says. “We have had a very positive run, benefitting from the quantitative easing and the low interest rates environment. But the reality is that it is in the Fed’s interest to maintain that backdrop not just now, but a long time into the future. In addition, we have improving fundamentals. So actually the environment is incredibly positive for commercial real estate and in turn for REITs, which after all are just holding companies for property.” It’s a view that NAREIT’s Brad Case

supports, especially given the sharp correction in prices in the latter half of 2013.“There was perhaps a perception that REITs had become over-valued before the sharp downward correction,” says Case. “I would now argue that some other asset classes are at that point following the rapid upturn in 2013 and that most REITs look well priced going into 2014.” NAREIT points to 16 periods since 1995 when interest rates rose sharply, but REITs still performed well. Case also argues that a property cycle generally last 18 years, and that we are less than five years into the current one. He also sees this as an advantage for REITs in a market that has become more supportive of property acquisition once again.“If you look at the last three years, REITs bought the vast majority of institutional grade product,” he explains. “Now REITs are not the only game in town, because there is far more private equity money pursuing real estate. The difference is that REITs, unlike private equity, are not under

THE SLOW SPREAD OF ISLAMIC REITS

Swiss-based B&I Capital AG, with Al ntil this year, innovation in the Salam providing seed capital for the Islamic REIT segment was mainly fund. No definitive figures have been confined to the Asian market. The released on the size of the fund. government introduced Islamic REITs REITs are traded on exchanges, guidelines back in 2005. Al-Aqar KPJ rather like ordinary stock, investing in REIT was the first listed Islamic REIT, real estate directly, either through which specialised in the healthcare property acquisition or mortgates. In segment, which was followed a year general an Islamic REIT is a collective later by the Al-Hadharah Boustead investment scheme in real estate, in REIT, which focused on agricultural Photograph © Spectral-design/ land. Singapore soon followed suit, Dreamstime.com, supplied February 2014. which the real estate tenants operate permissible activities according to with a number of Islamic REITs setting Shari’a principles. Fundamentally there is not much up in 2010 and 2011, including the 2010 Sabana difference between traditional and Islamic REITs, the Industrial REIT which was listed on the Singapore investment objective, administration and structure of stock exchange.. Dubai Islamic Bank also set up the an Islamic REITs is very similar to a conventional REIT Emirates REIT at the end of 2011, worth around and the main difference is the way in which the $70m or so at the time. Since then the setting up of incomes of the Islamic REIT are derived and how the REITs has been patchy. Now Al Salam Bank has set fund is being managed (which governs, say the type up a Shari’a-compliant fund that will invest in listed of eligible tenants and the proportion of rental income Asian REITs.The fund will invest in between 15 and derived from these tenants). 35 equally weighted positions and be managed by

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

pressure to buy so they do not have to chase over-valued property.” This in turn means REITs may diversify from prime buildings in CBDs to look at better value regional and secondary properties. Case notes that the increasing stakes in REITs held by Japanese institutions and sovereign wealth funds will encourage greater internationalisation of investment in US REITs. Marasciullo also points to the growing rump of Asian money coming into prime US real estate – “A lot of global money has flowed into the gateway cities,”he says - and like Case he believes that will encourage REITs to go beyond CBDs. “The ‘burbs may well be back,” he suggests. “REITs are looking at fundamentals and are more prepared to go up the risk curve, looking at offices and shopping centres in tertiary and suburban markets where

they believe improving employment and trade can boost those locations.” The argument that REITs and interest rates are inexorably linked is also countered by Tom Bohjalian, a portfolio manager with Cohen & Steers, one of the biggest REIT-focused fund managers. “We expect REITs’ return profile to improve in 2014. Given the recent clarity around QE tapering and the accommodative guidelines for future rate hikes, we believe higher Treasury yields are now largely priced into current valuations,” he said in an advisory note. “Any further interest-rate headwinds are likely to be countered by improving real estate fundamentals, in our view, with returns varying widely across the REIT market depending on a company’s value relative to its pricing power and growth opportunities.” Bohjalian also believes that discounts to net asset value (NAV) could prompt

increased corporate activity. “If the market continues to price REIT properties below what they’re worth in the private market, we anticipate that more REITs will look for strategic alternatives to realise the value of their assets,” he reflects. “For example, acquisitions that wouldn’t have worked before may make more sense now: a company could offer to buy another’s assets at a premium to the current share price, but at a level that could still add to earnings growth due to the real estate’s underlying value.” For the moment, many investors have taken to believing that the current situation will mirror historical circumstances. However, those within the real estate sector believe that this is too simplistic. “All the fundamentals point to a good year for REITs,” says Marasciullo. “This is not like the old times, this is a new normal.” I

US REITS: THE UPS AND DOWNS OF 2013

eturns from listed US REIT stocks underperformed the broader equity market in 2013 for the first time in five years, according to the National Association of Real Estate Investment Trusts (NAREIT). The FTSE NAREIT All REITs Index, the broadest index of the listed US REIT market, gained 3.21% on a total return basis in 2013. The FTSE NAREIT All Equity REITs Index delivered a 2.86% total return, and the total return of the FTSE NAREIT Mortgage REITs Index fell 1.96% in the year, NAREIT reported. The S&P 500 delivered a 32.39% total return for the year. The dividend yield of the FTSE NAREIT All REITs Index at the end of 2013 was 4.43%, the yield of the FTSE NAREIT All Equity REITs Index was 3.91%, and the FTSE NAREIT Mortgage REITs Index yielded 10.31%. By comparison, the dividend yield of the S&P 500 at the end of 2013 was 1.98%. Some sectors of the REIT market delivered doubledigit returns in 2013. The commercial financing segment of the mortgage REIT sector delivered a 41.77% total return for the year. The lodging/resorts sector produced a 27.18% total return, and manufactured homes returned 10.46%. Most REIT market sectors produced single-digit returns for the year. The self-storage sector gained

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

9.49%; timber REITs increased 7.86%; the industrial sector gained 7.40%; free-standing retail rose 7.29%; and the office sector increased 5.57%. Listed REITs raised a total of $76.96 billion of equity and debt in 2013, an amount that surpassed 2012’s prior record of $73.33 billion. The 2013 number included $46.22 billion of equity and $30.74 billion of debt. A total of $5.71 billion was raised in 19 initial public offerings during the year – the largest amount raised in the largest number of IPOs since 2004 when $8.27 billion was raised in 29 IPOs. The offerings included 13 equity REITs spanning a range of property sectors and six mortgage REITs representing both the home financing and commercial financing sectors. The IPOs were approximately equally divided between the first and second halves of the year, and the bulk of the funds were raised in the second half. The overall size of the listed REIT industry grew in 2013. The industry’s market capitalisation increased to $670 billion at the end of 2013, up from $603 billion at the end of 2012, and the number of companies in the FTSE NAREIT All REITs Index grew to 203, up from 172 companies at the end of 2012.

MARKET TRENDS – FIXED INCOME

EUROPE’S PERIPHERY ENJOYS BUMPER START TO THE YEAR

In the first of a new series of commentaries from Tradeweb on the fixed income market, we look at the impact of slowly improving fundamentals in developed economies with the attendant impact on selected sovereign bond issuance.

Liquidity returns to Europe’s periphery markets HE SECOND HALF of 2013 set the scene for a long-awaited turning point in the course of the global economy. The Federal Reserve’s decision in December to wind down its stimulus efforts came amidst positive non-farm payroll and trade reports; while growth projections for the UK were revised upwards more than once in the last quarter. There was more good news in the New Year. The World Bank predicted more robust growth for 2014, led by a recovery in advanced economies and stronger performance by developing countries. The International Monetary Fund (IMF) also raised its global growth outlook to 3.7%, and upgraded forecasts for the US, UK and eurozone. Weaker than expected US jobs data for December published on January 10th didn’t seem to dampen a generally buoyed investor sentiment, as it was followed by encouraging retail sales and inventory figures. This was reflected in the fixed income markets, with Europe’s peripheral economies emerging as the primary beneficiaries so far. Data derived from trading activity on European government bond marketplace helps support the view that liquidity is returning to peripheral markets: January’s traded volumes for Spain were the highest ever on the platform, and up 51.9% year on year. Ireland’s first bond auction since its bailout exit in December raised €3.75bn, while the total order book amounted to some €14bn. Interest came mainly from European and US investors, as Ireland’s sub-investment grade sovereign rating with Moody’s might have deterred potential investors

in Asia. A long-awaited review on January 17th and a subsequent credit rating upgrade by Moody’s boosted the country’s efforts to restore confidence in its growth potential. Data shows that mid-yields for its ten-year benchmark government bond dropped to eightyear lows of 3.2% on January 21st. Hot on Ireland’s heels, Portugal saw the sale of its newly-issued five-year bonds on January 9th achieve similar levels of success, securing €3.25bn. The country is bracing itself for its own bailout exit, which could materialise as early as May 17th, according to the vice president of the European Parliament, Othmar Karas. On January 20th, tenyear benchmark bond mid-yields closed below just 5% for the first time since August 9th 2010. Spanish ten-year government bonds are also trading at pre-crisis levels. Month-end closing mid-yields of 3.7% were only higher than those of September 27th 2006. News of an increase in 2014’s planned issuance went down well with the markets, as it was accom-

panied by optimistic economic indicators including growing exports and an increase in industrial production. A January 9th sale of new five-year bonds and existing paper maturing in 2028 raised more than €5.2bn. Similarly, a triple bond auction a week later yielded €5.92bn for Spain—beating the target range of €4.5bn to €5.5bn—and demand was exceptionally high for its €10bn ten-year bond sold via a syndicate of banks on January 22nd. Italy emulated Spain and Portugal, as its borrowing costs dropped to record low levels during January‘s sovereign bond auctions. Average yields for its five and ten-year debt sold on January 30th fell to 2.4% and 3.8% respectively. Italy’s ten-year benchmark bond midyields closed the month at 3.8%, their lowest level since October 18th 2010. The volume of Italian government securities traded increased by 54.2% in January compared to the same month last year. Even so, while most of Europe’s peripherals seem to be shielded from the latest concerns associated with emerging markets, this has not been true in Greece’s case. The country started the month in the same upbeat manner as its counterparts, reaching its lowest yield since May 18th 2010 at 7.6% on January 10th. Month-end mid-yields, however, were up by a percentage point at 8.6%, highlighting Greece’s vulnerability to the recent emerging markets turbulence. I

Spain 10Y Mid-Yield 8 7 6 5 (%)

4 3 2 1 0 Aug 06

Aug 07

Aug 08

Aug 09

Aug 10

Aug 11

Aug 12

Aug 13

Source: Tradeweb. All data correct as of 31st January 2014.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

SECURITIES SERVICES

EUROPEAN CUSTODY SURVEY

In December last year 84 pension fund respondents and eleven consultants were polled online or by phone to look at the way that European pension funds used custody services in a survey commissioned by Société G n rale. In a period of market change driven by regulation that promotes transparency, market safety and improved and standardised reporting, the survey highlights clear shifts in the way pension funds outsource services. It also shows varying awareness across Europe about the way regulation will affect custody and administration of their assets and a growing reliance by pension funds on their investment services providers. At the same time large custodians and fund administrators are becoming more selective about which beneficial owners they will or will not treat with. How will these changes roll through the European pension fund investment landscape?

MAPPING EUROPEAN PENSION FUND UTILISATION OF INVESTMENT SERVICES OW STICKY IS the relationship between custodian and pension fund? What’s important to a pension fund when it chooses an investment services provider? These were guiding questions for the first part of this survey of a cross section of European pension funds and consultants. It is clear that some markets work to the beat of their own drum. Harmonisation of financial services may be the ultimate goal for the European Union, but pension provision continues to be a local game and the European market remains a patchwork of local/national rules and pillars of pension provision that impact on the nature of the relationship between client and custodian provider. The bulk of respondents tend to want to utilise as few custodians as possible across as many markets as possible. Some of the larger pension funds that responded, those with global operations for instance, appeared to exercise more ‘choice’; some explained that some providers had particular expertise in key regions or markets and were utilised for that reason. These respondents (just under 12%) say they have opted for a custodian in each jurisdiction in which they work. However, this trend is confined to firms that operate in two or three jurisdictions only. The majority of respondents from the larger pension

Photograph © Rolffimages/Dreamstime.com, supplied February 2014.

SUMMARY SURVEY RESULTS The cost of services is the most important element in choosing a custodian; however pension funds also want more customised services. Securities lending was rated the least important service provided by custodians. Collateral management and transition management, lookthrough services and data management and enrichment were all highly rated services, but many pension funds say they are under-utilised. There is a high degree of awareness of regulation among pension funds, but in some countries, they are indifferent to it.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

funds say they prefer to utilise one custodian provider to support them in all the jurisdictions in which they work. Different answers came from Italy, where pension fund segment (worth around €100bn) has for many years been mandated to work with a local custodian provider. However, regulation introduced in late 2012 has encouraged a much greater tie-in between pension fund and custodian providers, a point noted informally by survey respondents.

Testing the client relationship According to the survey few firms have switched custodian provider in the last three years. Some 78% of respondents have stayed with the same custodian firm for more than three years and only 7% have changed provider over the same period. As one respondent put it: “You have to have a really good reason to move from one provider to another.” This is perhaps inevitable. There are costs, administrative hassles, the trouble of marrying the expectations of legacy and destination providers, the expenditure on technology to ensure that reporting platforms are compliant with in-house systems and a host of other considerations involved. Switching custodians then is clearly difficult. Given the apparent reluctance of people to move provider, the results beg any number of questions. Do cus-

SECURITIES SERVICES

EUROPEAN CUSTODY SURVEY

ships with custodian providers irrespective of wider market considerations. The results also show that the reviews are relatively frequent: around once every three years. Objectively, this data suggests sustained adherence to good corporate governance practices across the continent. Relatively few respondents noted a breakdown of trust (only five responses) as the reason for a review; though 12 out of the 84 respondents noted that if service levels were poor, that would be a good enough reason to change provider. When asked how frequently they reviewed their custody relationships,

todians themselves lose business? What encourages clients to change their custodian provider? Is this stickiness reflected in the range and length of typical custodian contracts? What can be improved? Does this level of stickiness ensure that business planning is easier? What is the turnover rate of client accounts and how do individual custodian scores compare with the industry average? Is there any industry average or measure for turnover in custodian mandates? The survey shows that most pension funds believe that it is good practice to periodically review existing relation-

Diagram 1: Patterns in utilising custodians across geographies (the fewer the better?) 2

Not applicable No reply One custodian in specific markets only One custodian for all jurisdictions One custodian for each jurisdiction One custodian in local market

34 0 32 10 6 0

Diagram 2: How many custodians do you work with? (number of responses) No reply We do not use custodian services Three or more Two One

4 0 111 220 550 0

Diagram 3: So few firms have switched custodian provider in the last three years! (percentage of respondents – pension funds only) No response 11% p

Yes 7%

Don’t know ow 4% No 78%

respondents clustered around the three to five years and every three years or less segments. A number of respondents noted informally that despite some of the over-charging scandals that have dogged the investor services industry in recent years, large international pension funds have opted to stick with their custodians; with personal knowledge and relationships trumping any reputational issues. Many of the respondents voiced (informally) that pension fund trustees and executives responsible for working with custodian providers must “work hard at their relationship” with service providers to ensure they get the best value they can; a response that tallies with later findings in the survey where some reporting services are both outsourced and still conducted in-house as a counter-check. Even so, other considerations were also taken into account by respondents. Some 20 (23.8%) respondents, for instance, felt that a change in the pension fund’s asset allocation might precipitate a review; with only two respondents saying that any change in the ownership of the custody provider would encourage the firm to review its custody contract. Cost of services was a consideration for only 11 (14.2%) of respondents. The rise in the cost of services was noted across a range of responses; but not at an exceptionally high level in this part of the survey. Certainly, it has become a consideration for custodian providers and there is a plethora of anecdotal evidence that larger custodian providers are becoming more selective about the accounts they take on. This clearly creates opportunities for some of the smaller service providers over the longer term. An important question for pension funds is whether they accept that the costs of investment services will rise?

Knowing your client The survey shows the two most pertinent considerations among respondents were the ability of the cus-

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

considerations: though French and German respondents were more likely to cite the importance of press cover than respondents in the United Kingdom or Holland where these particular considerations were not as important. Points to compare and contrast with other results include: one third of respondents say the involvement of a consultant governs the appointment of a custodian; though this response was

todian provider to understand the specific requirements of the client and the cost of the services provided. These results gel consistently throughout the survey. (Please refer to Diagram 6, which provides consolidated figures.) The pension fund’s personal knowledge of the custodian and the custodian’s credit ratings were also important considerations. Survey results and reports about the custodian in the press were also notable

Diagram 4: How frequently do European pension funds typically review their custody relationships? No response We do not use custodians We don’t review our existing relationships More than seven years Every five to seven years Every three to five years Every three years or less Less than three years

3 0

not reflected in the section of the survey which looked at why pension funds used external advisors. Costs of services were clearly very important to respondents in this section (72% of respondents said so); yet only 14.2% said it might be a reason to change custodian provider (see Diagram 5). These results don’t necessarily contradict each other; but it shows how changing the context of a question might skew results. In summary, the ability to understand the needs of pension funds, the cost of services, personal knowledge of the pension fund and the credit rating of the service provider were the most important reasons governing the choice of custodian.

Other considerations

6 12 30 0 0

Diagram 5: Why do Europe’s pension funds regularly review their custody relationships? (more than one reason nominated) 4

No response 1

Other reasons (stated) Services are/were too expensive

11 20

There is a change in the fund’s asset allocation Client service is/was poor

13 5

There is a breakdown of trust There is a change in the ownership of the custodian provider

2 4 48

It is good practice to periodically have a review

Diagram 6: Which of the following elements govern your choice of custodian? (more than one reason can be ticked) No response Other reasons (stated) Existing relationship with custodian providers An ability by the firm to understand the client’s needs Reading about the firm’s services in the trade press Costs of services Recommendations by an advisor Personal knowledge of the firm Survey results Credit ratings

5 1 223 552 227 661 332 334 332 3 34 0

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

Firms generally kept to the confines of the survey: and to be fair, those firms that responded by phone were (of course) tightly guided through the questionnaire. More than half of all responses however were filled in online and an interesting feature was thrown up. Respondents were asked to rate the relative importance of various services elements provided by custodians only if they had changed custodian provider within the last three years. However, 44 respondents filled in the segment in any case. Given the eagerness of respondents to impart their views, their responses have been included in the results and they add consistency and weight to the remainder of the research. There were no restrictions on the number of elements that each respondent could mark as important; though each element was rated from 1 to 5, where 1 was regarded as extremely important, 2 was a major consideration, 3 was rated a consideration, 4 was rated a minor consideration and 5 was rated not a consideration at all. In other words, the higher the score achieved, the lower the importance of the element. Again, the findings chime with earlier results. The capacity to manage multiple assets and assets in

SECURITIES SERVICES

EUROPEAN CUSTODY SURVEY

implications of regulation would affect the provision of sub-custody services over the coming decade.

Diagram 7: Relative importance of business elements (rated by 44 pension funds)

Awareness of regulation

Capacity to manage multiple types of assets and in different countries Added-value services which enhances the returns Knowledge/reputation of the provider on the market Quality personnel and training programs Effective service level agreements Flexible client facing systems Willingness to accept responsibility for risk (i.e. losses from operational reinvestment and other risks) Usefulness of reporting (ie. covers all your performance valuations, risk management and auditing needs) Transparency of fees, spreads and custodian charges Costs (fees, spreads, charges) Creditworthiness Demonstrable commitment to the business (i.e. continuing to invest in the business)

different countries was most highly prized, chiming with the early results about the preference for working with a single custodian able to work across multiple jurisdictions. The importance of cost effective services also rings true with earlier findings, with respondents noting also that transparency around fees, spreads and custodian charges were equally important. In a period where a number of custodian providers have found themselves on the wrong side of regulators because of overcharging for services; these findings write large the concerns of trustees and pension fund administrators. Creditworthiness and reputation of the provider were also important considerations as well as demonstrable commitment to providing services. The growing incidence of larger custodian providers becoming more selective about the clients they take on and even those that they keep is noted by respondents. Clearly, costs and returns on investment are becoming important on both sides of the buy side/sell side equation: with some of the larger houses no longer wanting to deal with smaller pension funds and asset managers because of the relative

lack of revenue that the smaller accounts provide. This might even have implications (over the medium term) as to the size of the asset management firms employed to take on invested assets. In future, asset management firms will not only be providing information on portfolio returns, they may also have to provide testimony as to the custodian/collateral provider and settlement platforms they employ. However, that is longer term conjecture based on the musings of some of the pension funds in the survey. Even so, a large number of respondents stated informally that they were anxious to ensure that their provider was genuinely committed to the provision of custody long term. This also has repercussions for those providers, particularly domestically based custody providers (sub-custodians in many instances) across Europe. This was picked up by a discrete set of respondents: three questioned whether all the smaller European custodian houses would survive over the long term; four wondered whether the cost of providing services, the need to spend wholesale on technology and the

The last of these points was covered in detail by the survey. Questions covered the regulations which are either being implemented, are about to be implemented or have been implemented in recent months (please refer to the regulations guide box). A long essay can be written on this element; the cluster and consistency of responses to both question segments illustrate the following: both pension funds and consultants are highly cognisant of the multiplicity of influences on the global investment market. There is also a high degree of awareness of the range of regulation that will impact both the pensions market and the international investment market. However, some markets are more indifferent to regulation than others and there are significant differences between markets in the overall rating of that regulation From the results it is clear that Icelandic pension funds are more sanguine about the introduction of European legislation impacting on the pension fund segment: while French pension funds, Luxembourg pension funds, Swedish pension funds and to a lesser extent Danish pension (on some particular issues such as IORP and UCITS 5/6) funds are much more involved and concerned about the implications of incoming and current regulation on the pension fund segment and the operation of the securities services market. The United Kingdom is pretty neutral overall and Italian pension funds are consistently less interested in them. From the research results it was hard to know why: as many of them declined to comment in detail on this segment; though one respondent noted that with so much internal change underway because of national legislation it was hard to then focus on the raft of international rules which would ultimately affect them.

FEBRUARY/MARCH 2014 â&#x20AC;˘ FTSE GLOBAL MARKETS

Diagram 8: Mapping the importance of regulation across European pension funds: (the lower the score, the greater the importance) 2.0 1.5 1.0 0.5 0.0

ed Sw

m Lu

ur g bo

Ita

d lan Ice

lla

y rm

Fr an

d Fin

-1.5

lan

ar De

lgi

-1.0

-0.5

AIFMD

EMIR

FATCA

Solvency II

IORP

FTT

UCITS 5/6

CSD Regulation

Target 2 Securities

Securities Law Directive

Macro-considerations The survey also looked at the susceptibility of pension funds to macro market developments. Notable exceptions to the results in this segment were the Italian responses. Many of the responses were only half or partially filled, negating the rele-

vance of the national result. French, German and UK respondents (overall) showed the greatest awareness and concern over the imposition of macro factors on their business and investment outlook. The cluster of responses between 0.50 and -0.50 signify a growing aware-

ness of the role of macro-factors on the operation of the markets and decision making. The preponderance of responses around general market conditions (interest rate movements and market volatility) may be a reflection of the extended post-recessionary period in which market volatility has been

Diagram 9: Mapping the importance of macro factors to European pension funds (the lower the score, the more important the element) 1.5

1.0

0.5

0.0

m xe

en ed

bo ur g

ly Ita

d lan Ice

nd lla Ho

an y m

ce Fr an

d Fin

lan

k nm ar

Ge r

-1.5

Be lg

-1.0

ium

-0.5

Risk Management

Governance

Costs

Market conditions (low IR/market volatility)

Domestic market regulation

European market regulation

FTSE GLOBAL MARKETS â&#x20AC;˘ FEBRUARY/MARCH 2014

SECURITIES SERVICES

EUROPEAN CUSTODY SURVEY

pronounced. In recent months, the threat of European and North American central banks to taper quantitative easing was a regularly voiced concern: with more than one fund noting that it would involve a meaningful change in asset allocation. The importance of risk management and proper governance procedures also figured highly across the respondent survey set, reflecting perhaps an understanding that market change would require enhanced attention to these activities and this understanding also laid the groundwork for the next round of analysis.

To outsource, or not? Respondents from the United Kingdom show a noted preference to outsource services, while German respondents look to defer to in-house services. French responses on the other hand look to be more nuanced. What does this mean? That German pension funds have better in-house analytics? That they can handle master custody services? The fine balance is also reflected in the approaches of consultants to the same question. Overall, in Europe in house services among pension funds predominated: though it is a relatively close run race. Some 53.6% of respondents ran the services in house, with 47.6% outsourcing. Charts 10 and 11 show that even in complex activities, such as compliance monitoring and master custody, pension funds predominantly prefer to handle operations in house. The results highlight the contrast between the approaches in the United Kingdom where responding funds have preferred to outsource activities. Clearly the battle for the hearts and minds of pension funds is still active: what is behind the need to keep so much control of the analysis of risk and performance in-house? Is this a costly and unnecessary duplication of resources: or an important process in providing market data that is transparent and accurate? If there is the need

Diagram 10: Outsourcing service functions: Pension funds versus the consultants view FUNCTION/ Total RESPONSE responses Asset management Outsourced 40 In-house 46 No reply 7 Doesn't apply 0 Portfolio evaluation Outsourced 38 In-house 52 Doesn't apply 4 Compliance monitoring Outsourced 34 In-house 49 Don't know 3 Doesn't apply 6 Analytics/Performance risk Outsourced 32 In-house 45 Don't know 3 Doesn't apply 7 Master custody Outsourced 31 In-house 33 Don't know 4 Doesn't apply 8 No reply 8 Position keeping Outsourced 23 In-house 27 Don't know 3 Doesn't apply 7 No reply 3 Other services Outsourced 0 In-house 1 Don't know 0 Doesn't apply 1 No reply 0

% of total

UK responses

German responses

47.62 54.76 8.33 0

12 3 1 0

4 12 0 0

3 8 0 0

6 4 0 1

45.24 61.90 4.75

11 5 0

4 12 0

4 9 0

6 5 0

40.48 58.33 3.57 7.14

9 4 2 3

3 13 0 0

1 10 1 0

5 4 1 1

38.1 53.57 3.57 8.33

10 4 2 1

3 10 0 2

1 10 0 0

4 7 0 0

36.9 39.29 4.76 9.52 9.52

10 4 1 2 1

4 10 0 1 2

1 9 0 2 2

4 4 1 1 1

27.38 32.14 3.57 8.33 7.14

13 2 0 1 2

2 6 0 4 3

1 5 1 2 4

4 2 2 2 1

0 1.19 0 1.19 0

5 0 0 0 12

1 3 0 1 9

1 1 0 3 9

4 2 0 3 1

for this, what implications are there for the custodian? Do the results suggest that as pension funds adopt more international and complex asset allocation strategies that they have become increasingly sophisticated operations themselves? As custodians themselves redefine their service set (and which firms they provide services to) in the wake of regulation such as AIFMD and EMIR, for instance and the growing cost of providing services to beneficial owners and asset management firms, is one solution an increased sharing of responsibilities

French Consultant responses responses

and administrative functions between client and provider? Or, is the outsourcing model the right one for both the client and the sell side? Is it a question of cost? Traditionally custodians charge pension schemes a fee to physically hold assets (or ownership certificates) and keep a track of their movement as managers buy and sell on the scheme’s behalf. Not all pension schemes have their own custodian—investors in pooled funds often access custodial services through the fund manager—but ‘segregated mandates’ need a custodian.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

Until the 1980s the vast majority of pension fund assets were concentrated in domestic markets. Since then however trustees and pension fund administrators have increasingly allocated scheme assets to markets all around the world to capture greater returns. This has impacted on the way that pension funds utilise their securities services provider. While many of Europe’s heavyweight corporate pension funds have to comply with international accounting standards that require greater transparency, custodians typically carve Europe into different camps. There are countries such as the UK, the Netherlands and the Scandinavian states which, thanks to domestic regulation as well as accounting laws, are home to the more sophisticated and mature pension fund schemes. While there may be nuances in the different legislation, the common theme is the focus on valuing liabilities using market rates. For example, in Holland, under the Financieel Toetsingskader (FTK), pension schemes have to discount liabilities by market rates and not by the standard 4% that had prevailed previously. In the UK, by contrast, the financial reporting standard FRS17 has brought a pension’s surplus or deficit fully onto a company’s balance sheet. In Denmark and Sweden, on the other hand, both operate so called traffic light solvency systems, which has also sharpened the focus on liabilities. Denmark debuted its traffic light system in 2001 while the Swedish version came out last year for its insurance industry. It uses the three signals —green, yellow and red—to help funds monitor their exposure to different classes of risk including share prices, exchange rates, Swedish and foreign interest rates. Germany meantime is bogged down in a host of strict accounting rules and guidelines. The country is also home to structures and vehicles which do not appear in any other jurisdiction. These include both spezialfonds, which are

Diagram 11: What services should pension funds utilise fro their custodian provider? (Ranked in importance: 1 being very important/5 being not important at all) Services to be utilised Securities lending Repo Collateral management Transition management Look-through services

TOTALS Ranking 212 2.83 202 2.69 181 2.41 188 2.51 176 2.35

geared to hold the investments of one or more institutions, and the kapitalanlagegesellschaft (KAG) which is the legal entity asset managers must establish in order to manage and sell funds. They do not apply for the selling of registered foreign funds into Germany. Some years ago, the MasterKAG or multi-manager funds came onto play, which are now replacing the KAGs. While things are slowly changing, Germany’s pension fund industry has lagged behind many of its North European peers. Leading lights such as ABP, PGGM, AP Fonden, the UK’s Railways Pension Scheme and more recently the London Pensions Fund Authority have already broadened their asset class as well as geographical horizons to Asia, emerging Europe and the Middle East in search of returns. They have embraced new technology such as algorithmic trading and direct market access (DMA) and are currently adopting more alternative investment strategies and beefing up their employment of derivatives. The research results highlight differences between the requirements of national pension funds, with added colour provided by the sophistication of the individual schemes. The results then suggest a market in flux. Does this now provide opportunities for custodians to present a case that analytics can be effectively provided out of house across continental Europe, particularly as the asset mix becomes more complex and international? Or will the divide remain? Although in the long run defined

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contribution (DC) plans are likely to become the order of the day. The challenge for the custodian is to provide a spread of bread and butter (no pun intended) core services but also to keep pace with the larger pension funds which are making forays into alternative asset classes and more complex strategies. This trend will only accelerate once tapering of the quantitative easing programmes extant in European markets really gets underway in 2014 and firms in search of returns turn to a greater variety of asset classes and investment styles to achieve them. Is there opportunity here? As the survey has noted: changes in asset allocation have a significant impact on the choice of custodian utilised.

Using investment services To keep up with pension funds’ demand, some custodial services that were once considered ‘value added’ are now provided as standard. These include cash management, foreign exchange and securities lending and the research looked at this services segment in more detail. Some anomalies were noted in the responses related to the importance of services provided by custodians. Interestingly, securities lending was rated the least important service, while collateral management and transition management, look-through services and data management and enrichment were all nominated as important services. Respondents were asked how important a range of eight service sets in the graph below (Diagram 13). Each service was ranked, where 1 was very important and 5 not important at all. An average was taken of the total responses and the lower the overall score, the more important the service. The remaining replies were clustered around the mid-point. Since a fifth of respondents did not know what fund trading entailed, the result is something of an anomaly rather than an indication of its importance. Researchers then looked at some of these product sets in more detail.

SECURITIES SERVICES

EUROPEAN CUSTODY SURVEY

SURVEY T&Cs T

he survey was undertaken between October 1st and November 22nd 2013. Some 84 pension fund respondents and 11 consultant respondents make up the survey population. Surveys where respondents had replied to less than 30% of the questions proffered were abandoned. Efforts were made to ensure that key market segments were adequately covered across key European markets, including the United Kingdom, France, Germany, Holland (the Netherlands/Benelux), and the Nordic region. In addition 11 consultants were polled on elements in the provision of investment services in Europe. The results of this poll are presented separately and where significant compared and contrasted with the pension fund responses. The response rate to the survey was (on average) one in five. The survey respondents came from a wide range of pension funds: the largest having assets in excess of €44bn. Nonetheless, the survey responses were firmly in the mid-market to large pension fund segment. Respondents were guaranteed anonymity: this was particularly important in assuring respondents that the survey was not about assembling a beauty parade. Neither was the survey approached to ensure that certain results were achieved: if the respondent said they were uncomfortable providing insight and/or a direct response to a specific question, then the researcher did not press. Equally, when the respondent wanted to add some local color to their responses, appropriate notes were taken. The following charts Graph 1 shows the broad designation of pension funds polled and the value of the assets they managed. There was a wide disparity among responding pension funds, giving an effective cross section cut of pension fund approaches and opinions across more advanced European markets.

Diagram 12: Value of assets (€) under management (AUM) by responding pension funds (number of respondents) No response

Less than €1bn

€1bn to €5.99bn

€6bn to €15.55bn

€16bn and over

17 0

When questioned about the utilisation of specific services, respondents were generally reluctant to explain internal approaches to securities lending, collateral management, transition management and so forth. Understanding how pension funds utilise these service resonate for the custody provider. While core custody offerings such as safekeeping,

settlement, income collection, tax reclamation, corporate action and proxy voting are still important, it is not where the money will be made. Moreover, custodians have a better chance differentiating their brands, products and customer service at the higher margin businesses rather than at the commoditised end of the spectrum.

Dutch, Nordic and pension funds in the United Kingdom look to be more progressive and adventurous in their asset allocation strategies, which mean they invest in increasingly more complex asset classes such as private equity, derivatives and hedge funds. Questions for the custodian provider in these instances, must hang around getting closer to the clients’ investment strategy. A number of respondents anecdotally mention they are increasingly dependent on their custodian provider in this regard. It is no longer just about the processing but offering value-added services such as independent valuations of derivatives, collateral management as well as performance measurement and risk management. Historically, pension funds have been reluctant to be involved in securities lending, but according to a number of survey respondents, they say they are much more aware of the additional returns that can be generated by the service. They also realise it can help cover the costs of custody. However, the growing reluctance among mainland European regulators to leave securities lending alone either directly or indirectly through the imposition of limits on shorting stock has complicated matters, noted respondents in Germany. From the results, collateral management looks to be an opportunity for service providers as approaches to the service set (collateral management, collateral optimisation, and collateral transformations excepting among the larger pension funds). The survey results suggest that there is scope to marry the results in this segment with the responses related to asset allocation. The approaches however are varied and detailed. Clearly, it is different for each firm. Respondents were most at ease with questions related to transition management with respondents appearing to understand the relevance and scope of the service, but still (perhaps) underutilising it. I

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TRANSITION MANAGEMENT

What’s eating TM? Faced with perpetually tight margins (and even tighter regulations) banks have grown less tolerant of services that may prove more problematic than profitable—thus in 2013 several notables simultaneously bid adieu to all or most of their transition management programs. What are the implications of this shrinking field of TM players? Which surviving firms stand the best chance of securing the business of those who were suddenly severed? From Boston, Dave Simons reports. HEN THE QUESTION was recently posed,“How are things in transition management these days?” some of our normally chirpy friends in the financial world were noticeably mum. Actually, who could blame them? Fiduciary requirements nowadays offer very little wiggle room; and the rise of the multi-transition manager “panel”and various other elements have combined to weigh on commissions (rates have fallen by as much as 90% over the last decade, according to consultancy firm Harbor Analytics), making volume essential to continued profitability. Moreover, those systemic asset allocation shifts which have been at the heart of transition management since time immemorial, are simple not there right now. It seems that

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when the going is good (well, let’s be realistic, good-ish), people stay put—and with equities in the US reaching their highest levels since the Clinton days, investors have had little cause to shuttle from one fund to another. Like FX, securities lending and other ancillary services offered by custodian banks, transition management has itself come under heavy regulatory scrutiny of late, as officials work to ensure that providers stay on the up and up. In January, the UK’s Financial Conduct Authority (FCA) levied £22.9m ($37.5m) in punitive charges against State Street UK’s transitions management division, stemming from“substantial mark-ups” on EMEA-based transitions dating back to 2010-2011.

TRANSITION MANAGEMENT

In a statement, State Street expressed“deep regret”over the matter and indicated that it has “worked hard to enhance controls to address this unacceptable situation.”Even so, the firm continues to pay for the past. In its January third quarter earnings report, State Street reported a 5.5% decline in brokerage and related fees compared to the previous quarter, due in part to a drop in transition-management revenue. Then, in mid-February Ireland’s National Pension Reserve Fund (NPRF) terminated the mandate held by State Street Global Advisors (SSGA) to manage €650m worth of equities, shortly after the publication of a report by the UK’s Financial Conduct Authority into over-charging in the bank’s transition management unit in 2010-2011. The Irish-based SSGA unit was not involved in the overcharging. One of the clients that had been overcharged was however Ireland’s National Treasury Management Agency (NTMA), for whom the NPRF manages assets. State Street reportedly had paid back about €3.2m to the NTMA following the discovery of overcharging. The affair ultimately highlighted the heavily nuanced role that transition management plays in the securities services pantheon. While acknowledging the ability for transition managers to provide pension plans and other institutional clients with stronger returns and more reliable risk management, such benefits may be offset by the persistence of opaque fee structures, overly complex documentation and the use of affiliates, claims the FCA, which in turn could lead to “poor customer outcomes.” Accordingly, last year the agency announced its intentions to call upon others in the business as part of a general review of industry practices“to assess whether customers are being treated fairly.” At an asset-management conference in London this past October, Clive Adamson, FCA director of supervision, noted that service levels and product transparency have improved, yet implored clients of transition management to continue to hold providers’ feet to the fire to ensure they are continuing to receive services as promised and at the right price, “just as you would do for any third party provider.”

Tough times Faced with perpetually tight margins—and even tighter regulations—banks have seemingly grown less tolerant of any service that could prove more problematic than profitable. Thus, in 2013 several notables bid transition management adieu, among them JP Morgan (which shelved its US and EMEA transition management divisions while holding on to its Australian operations), Credit Suisse (which ceased its US-based transition services), as well as New York’s ConvergEx (which shuttered all but its US TM facilities). Earlier this year reports suggested that Northwestern Mutual Life Insurance may consider selling the asset-management division of its subsidiary Russell Investments, itself a key player in the US transition-management field. With commissions on larger transitions reaching historical lows, William Conlin, president and chief executive of New York-based independent agency brokerage Abel Noser,

Nick Bonn, EVP and head of State Street’s global portfolio solutions business, says that clients expect more out of their transition managers today than in the past. “In my view, best execution and performance measurement are the status quo. Increasingly, transition managers are adding more and more services to help client manage costs and risk. Some of these services include stepping in to manage assets on a short term, interim basis during a transition, while still managing costs, best execution and performance. Similarly, clients expect explicit reporting that gives transparency into their transaction, including risks and fees.” Photograph kindly supplied by State Street, February 2014.

understands why it is no longer worth the risk for some providers. Still, Conlin questions why so many elected to jump ship at once.“All of a sudden this business isn’t profitable enough to stay in the game? It’s been an unusual turn of events, to say the least.” Which is not to say that Conlin doesn't welcome the possibility of an expanded clientele. While some larger banks have been keenly impacted by heightened transparency requirements, agency brokerages are designed to be transparent and therefore likely stand the best chance of prospering during the current period. In a winnowing field of TM providers, firms like Abel Noser could wield considerable clout as the industry looks to get back on track. Which, says Conlin, needs to begin with a thorough re-examination of TM marketing practices. “You have to be a bit skeptical about some of the activity that has taken place these past few years,” says Conlin. “There have been too many providers with the attitude that they can just win the transition mandate first and worry about how to handle the executions later. And if the results aren’t satisfactory, it doesn’t matter, they’ve already got the business and the money’s in the bank.

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

Which obviously has been bad for the industry as a whole, and is one of the reasons why managers in general need to reassess what Wall Street has been selling as a transition-management product.” Tweaking the pre-trade cost analysis regimen in order to quickly secure a deal is one such area, notes Conlin.“There is a school of thought that instead of using an actual pretrade, the transition manager should simply offer the client ‘x’, rather than getting into these long drawn out explanations about standard deviations and the like, just so they can win the bid. The consumer is led to believe that the lower the pre-trade, the better the broker—which, unfortunately, isn’t always the case. Which is why it is imperative that sponsors hold their transition managers accountable for their pretrade numbers, and, more importantly, understand the intrinsic value of having accurate pre-trade analysis.” Reducing the complexity of the transition process is also paramount. “A good pre-trade should provide the client with substantive information around what the targets are and, subsequently, whether or not the broker was able to achieve their goals,” says Conlin. “Yet in some instances where third-party analysis was involved, sponsors have had some difficulty explaining to us what the goals were at the outset. You have to wonder how this process got so complex, when in reality it’s something that buy side traders do every day, just selling and purchasing stock. So if we can simplify the process going in and then hold all parties accountable, that should help de-emphasise the selling aspect and in turn bring pre-trade back to reality. Clients may not always like the numbers, but chances are they’re going to be a lot closer to the end result than what they’re hearing right now.” Additionally, says Conlin, brokers should know right from the get-go what will work for the client, what may not, and be able to tell them in no uncertain terms.“In other words, if a client has a deadline of three days and there are certain stocks in there that could take a week to execute, the sponsor needs to be made aware so that tremendous costs are not incurred as a result.” While generally in agreement with the overall aims of the regulatory agencies, Conlin nevertheless has some reservations.“The fragmentation that has occurred as a result of having upwards of 60 different trading venues has been counterproductive and ultimately gets in the way of best execution,” says Conlin. “When in reality what we need is some consolidation of information. So while the legislative goals have often been good, the implementation has at times led to unintended consequences.” Consolidation, along with the changing needs of clients over the last several years, has spawned an evolution in transition management, particularly around transparency standards, concurs Ben Jenkins, practice lead, transition management at Northern Trust. “There are a lot of firms that are now considering third-party analysis, or are otherwise bolstering transparency around equity, fixed income and even FX, in an effort to get up to speed with the new market requirements,” says Jenkins.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

William Conlin, president and chief executive of New York-based independent agency brokerage Abel Noser, understands why it is no longer worth the risk for some providers. Still, Conlin questions why so many elected to jump ship at once. “All of a sudden this business isn’t profitable enough to stay in the game? It’s been an unusual turn of events, to say the least.” Which is not to say that Conlin doesn’t welcome the possibility of an expanded clientele. Photograph kindly supplied by Abel Noser, February 2014.

“By contrast, at Northern Trust transition management has long been a fiduciary offering, with a major emphasis on transparency—so in effect this kind of development hasn’t had a huge impact.” Nick Bonn, EVP and head of State Street’s global portfolio solutions business, says that clients expect more out of their transition managers today than in the past.“In my view, best execution and performance measurement are the status quo. Increasingly, transition managers are adding more and more services to help client manage costs and risk. Some of these services include stepping in to manage assets on a short term, interim basis during a transition, while still managing costs, best execution and performance. Similarly, clients expect explicit reporting that gives transparency into their transaction, including risks and fees.” Bonn’s TM predecessor at State Street, Ross McLellan, knows all too well the ramifications of overseeing a transitions business in an under-lit environment, having served as State Street Global Markets’ senior managing director at the height of the UK division’s mark-up hubbub (McLellan and UK colleague Edward Pennings departed the firm in October 2011). Now president and CFA of Hingham, MA-based consultancy firm Harbor Analytics, McLellan himself has sought to combat opacity by providing asset owners and

TRANSITION MANAGEMENT

other participants with independent evaluation of transaction costs covering a range of investment classes. “The quest for improved transparency among investment managers, hedge funds and pension funds has helped level the playing field for all providers,” asserts McLellan, author of the soon-to-be-released whitepaper The Future of the Transition Industry. Conditions are such that several new participants could help fill the void left by JP Morgan et al, says McLellan, as declining equity volumes and commissions force brokers to look elsewhere for new sources of order flow. While only one or two will likely survive, he says,“What they will find is that the client base will want experienced personnel and systems that are specifically designed for transition management.” With TMs increasingly tapped to handle short-term investment management assignments, the time seems ripe for bona fide asset managers to get involved as a fee-based rather than commission-based service, without utilising an affiliated broker, offers McLellan. Meanwhile, heightened scrutiny around foreign exchange (FX) will compel transition managers to reduce trade executions at 4pm GMT (aka the WM/Reuters fix, when major FX benchmarks are typically set). Additionally, says McLellan, “most transition managers will need to start charging for FX trading, as they will no longer be able to internalise order flow to their affiliated FX desks.” Furthermore, managers who once received favourable rates from non-affiliated banks to trade at the WM will no longer be afforded such treatment, “given the scrutiny and the declining volumes traded at the fixing points”.

APAC opportunities While Boston-based Cerulli Associates sees the US leading the globe in overall asset growth near term, there will still be bright prospects within the Asia ex-Japan region in particular, fueled by an estimated 40% rise in available institutional assets over the next three to four years. Pension funds and sovereign-wealth programs figure prominently in the Asian growth story, the result of an expanding middle class in need of plausible investment opportunities. Asia is not without its unique organisational challenges, of course; in the absence of a universal regulatory standard a la UCITS or AIFMD, managers are compelled to adopt different strategies for different regions. And while investors’ risk tolerance and level of sophistication has risen, so have their demands for clarity. In Asia, the role of the transition managers continues to expand, says Michael Jackett-Simpson, Asia head of transition management at Citi, and as a result “we are often seen by our clients as an extension of their internal portfolio management and execution desk. Citi's business model as a broker also encourages clients to engage in a range trading-execution services, including futures and FX execution, in order to manage downside protection efficiently.” Last year, Citi retained Sandeep Gurkhi, a veteran of both State Street and Mercer Investment Consulting, as vice president for its transition management and pension

Ross McLellan, president and CFA, Harbor Analytics. McLellan knows all too well the ramifications of overseeing a transitions business in an under-lit environment, having served as State Street Global Markets’ senior managing director at the height of the UK division’s mark-up hubbub (McLellan and UK colleague Edward Pennings departed the firm in October 2011). Now president and CFA of Hingham, MA-based consultancy firm Harbor Analytics, McLellan himself has sought to combat opacity by providing asset owners and other participants with independent evaluation of transaction costs covering a range of investment classes. Photograph kindly supplied by Harbor Analytics, February 2014.

services division, with an eye towards boosting the firm’s servicing capabilities particularly within Australia’s burgeoning pension-fund space. Through September, Citi had executed approximately AUD10bn in Australian transition trades over a 12-month period. Going forward, banks and trading firms will likely continue to find it challenging to harvest transition management revenue, contends McLellan. “As growth can only come from cost cuts, those with limited market share could exit as well.”For the remaining roster of providers, however, any further reduction in the TM ranks will likely be regarded as a bona fide growth opportunity, thereby leaving asset owners with a wealth of choice. “It is really about clients connecting the dots and realising the benefits of transition management,”asserts Jenkins.“We have seen our own growth opportunities among of client segments that have become acclimated to the idea of transition services, not only with respect to cost reduction, but risk mitigation as well. As clients gain greater exposure to these services, we feel they will become more aware of the intrinsic value of transition management.” I

FEBRUARY/MARCH 2014 • FTSE GLOBAL MARKETS

The experts agree: achieving price discovery/best execution while monitoring market structures across a number of different asset types is not for the faint of heart. David Simons reports.

TRANSITIONING A MULTI-ASSET WORLD HERE WAS A time when transitions were almost exclusively one-to-one type events—say, selling a one index based portfolio while picking up a FTSE100 based strategy. Compare that to a transition involving multiple strategies using perhaps a dozen different managers and possibly multiple custodians, all the while subsequently lining up various moving parts and accounting for differences in timing, trade horizon, settlement horizon and other discrepancies—and one can easily see the problems that may arise when moving your average multi-asset class portfolio. “It doesn’t really matter how good a trader you are if you underestimate the scope of an event or can’t ensure that all of the operational details are handled properly,” maintains Ben Jenkins, practice lead for Northern Trust’s transition management group. Project management is central to trouble-free TM, says Jenkins, and thus remains a core part of that firm’s transitions business. “This has been particularly relevant given the emphasis on multi-asset class transitions, which can include everything from equities to fixed income as well as US and foreign regions, but also the blending of different vehicle

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types such as separately managed funds versus co-mingled funds, or mutual funds versus cash-for-equity.” William Conlin, head of independent agency brokerage Abel Noser, agrees that multi-asset class portfolios can present significant challenges when making transitions. “A ‘pure’ transition is basically moving A to B, however the more you add to that process, the more difficult things can become both from an operational and performance standpoint,” he says.“Not only do you have to consider the ramifications of, say, mixing bonds and equities, but there are also settlement and timing issues, particularly when working on a global basis. It’s easy to see how real problems could arise should you try to move everything at once.” For certain pensions, endowments or foundations where a longer-term strategy is advisable, such transitions can do more harm than good.“Even if a sponsor may not be aware of that, a good manager should, and needs to say so,” says Conlin. “Unfortunately, there has been a lot of overzealous selling on the part of the Street, or in some instances consultants have come in and wanted to make these moves spontaneously.” Hence, it behooves the client to approach these

TRANSITION MANAGEMENT

situations with a healthy dose of skepticism.“It never hurts to be vigilant and ask the hard questions,” concurs Conlin. When it comes to achieving reliable multi-asset class price discovery and best execution, transitions have to be handled as a portfolio, says Nick Bonn of State Street’s global portfolio solutions business,“because making changes to one asset class will have downstream effects on the risk associated with the rest of the portfolio. Thus, transition managers have to be experts in market structure across asset classes. At State Street, we do that by having traders and analysts dedicated to the various asset classes, including fixed income, equities, and others, to help ensure price discovery and best execution across client portfolios. We also deploy systems that allow us to analyse portfolios by asset class, yet still manage the risk across the entire portfolio.” Although different asset classes can easily be transitioned independently, if the portfolios are in any way linked—that is, as a single entity restructuring across asset classes—the transition should be treated as a single cost and risk-management exercise, says Steven Dalzell, EMEA head of transition management at Citi, assuming it is operationally practical and

Ben Jenkins, practice lead for Northern Trust’s transition management group. “It doesn’t really matter how good a trader you are if you underestimate the scope of an event or can’t ensure that all of the operational details are handled properly,” maintains Jenkins. Project management is central to trouble-free TM, he adds, and thus remains a core part of that firm’s transitions business. Photograph kindly supplied by Northern Trust, February 2014.

STRATEGIES & SOLUTIONS FOR In the quest for the perfect portfolio transition, managers are looking outside the box to cope with macro market irregularities and the need for heightened transparency. How do they do it?

hen it comes to full disclosure around business practice and infrastructure, the transition management business has, in the words of Steve Kirschner, transition management managing director at Russell Investments, proven to be “a minefield of unseen hazards.” Accordingly, clients are likely to continue to apply pressure to ensure that providers meet their criteria around fiduciary oversight, revenue reporting, as well as adherence to the “T Standard”, the portfolio performance metric developed by Russell that seeks to add clarity to the outcome of a transition from the perspective of the asset-owner client. Given the continued emphasis on clarity, emerging tools in the transition management trade have typically been aimed at providing clients with improved transparency around execution, asserts Michael JackettSimpson, Asia head of transition management, Citi. Through its real-time viewing solution for client orders (via the BECS web portal), Citi clients are afforded a glimpse at the same data that project managers have been monitoring. Particularly during periods of heightened volatility, “this can be useful for clients to appreciate the strategies their transition manager may be looking to employ,” says Jackett-Simpson.

The optimal transition-management model not only offers clients a wide range of solutions and strategies, but, in certain circumstances, uses execution desks that are based in the local markets, says Jackett-Simpson. “Because of the evolving nature of the markets and changes to liquidity dynamics, having execution teams on the ground provides insights not typically obtained when operating outside of the region.” As clients seek additional granularity of execution information, transition managers must be able to demonstrate where and how liquidity can be accessed. “In Australia, for instance, clients have come to appreciate Citi’s optimised reporting system,” says Jackett-Simpson, “which highlights information that includes which exchanges, dark pools and algorithms are used in search of best execution. For Asian clients, Citi also sends execution dates that are time stamped and broken down at a stock and currency level.” With fragmentation on the rise, a transition manager's ability to cross flows off-market has also become vital. Citi has been able to use its market share in Australia to good advantage by commonly crossing 50% of required trading, notes Jackett-Simpson, which typically results in cost savings for its clients. As Ben Jenkins, practice lead, transition management at Northern Trust points out, the inherent misalignment in market hours and regional exposures on a global scale has the capacity to negatively impact a manager’s opportunity cost or implementation shortfall, key

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achievable to do so. “The holistic view of a multi-asset class investment portfolio has a different risk profile to the sum of the individual asset class specific portfolios, which has implications for trade strategy, risk management, hedging, trade timing and funding—all of which will impact the potential implementation of the optimal portfolio transition.” While efficient cost and risk management is paramount, actual trading strategies will vary significantly at the asset class level, adds Dalzell. “Methods of achieving price discovery and best execution will be influenced by the characteristics of each asset class, sub sector and security, including price, liquidity, speed of execution, transparency of pricing, cost of execution, and residual risk.” The ability to successfully manage all of these contributing factors throughout the execution phase of a transition, while also delivering operational efficiency and a high standard of client service, is largely dependent upon the skill and experience of the transition manager, says Dalzell. The complex nature of multi-asset class portfolio transitions, including the ability for TMs to take on short-term investment-management assignments, requires that managers

“be one part sell side and one part buy side,” asserts Ross McLellan of consultancy firm Harbor Analytics. Few systems are actually capable of handling these kinds of requirements, however, and as a result errors have been commonplace. “Compounding the issue is the operational risk calculation many banks are undertaking as a requirement for Dodd Frank. Thus, a transition business with a large error will be forced to have a high operational risk level, and therefore reserve capital against it.” Which of course begs the question, is all of this juggling really worth it? To clients that are perpetually focused on boosting funding levels, the answer is often a resounding ‘yes.’ “I think in large part it’s because clients and their consultants have become very comfortable with the transition management process,” concurs Jenkins, “as well as the knowledge that this isn’t just about cost reduction and risk management, but also identifying an asset-allocation goal and having the ability to execute effectively and efficiently on that decision, whenever you want, and in under a week’s time in some instances. For those kinds of clients, that can be a very powerful proposition.”I

A DEMANDING MARKET performance benchmarks used by providers to measure costs incurred during a typical transition. “In transition management, you really have to make assessments on an event-by-event basis,” says Jenkins, “mainly because by and large there are no two events that are exactly the same—which, when you think about it, is really kind of mind boggling. For instance, you may have what at the outset seems to be identical S&Pbased transitions, yet while their characteristics may be the same, there are subtle nuances at the allocation level that can make a huge difference. You also have to account for possible macro differences, including regional or country-specific issues, and so on. So there are a lot of these influences that can engage transition managers and compel them to think outside of the box in terms of efficiently handling a solution set.” A longtime staple within the TM trade, trade cost analysis (TCA) solutions continue to help managers keep a lid on transactional expense, maximizing alpha generation in the process. Last month New York-based agency brokerage Abel Noser announced updates to its post-trade TCA offering Trade-Zoom, which aggregates and measures trade data on behalf of managers, traders and other participants. The enhanced TCA tool includes improved analytics for evaluating the quality of executions received by both buy- and sell-side traders. Given the increased competition and consolidation within the markets, “TCA has never been more crucial,” says Abel Noser CEO William Conlin.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

Meanwhile, expertise in fixed-income transitions remains in high demand given the complexities involved, adds Jenkins. “In a deal-driven marketplace, sometimes there can be a disconnection between what a bond is worth on paper versus what the market will actually bear,” says Jenkins. “And because there’s much at stake based on the outcome of these individual events, there is a lot more emphasis on execution quality— clients really want full transparency around these types of transitions.” Hence, when looking at variance within a fixed-income portfolio—including whether it was market related, trade related, or the result of other factors—complete cost analysis is crucial, says Jenkins. “In this way you have a core concept of how you started, where you ended, and what the variances were in between.” For his part, Harbor Analytics’ head Ross McLellan emphasises the importance of third party analysis of transition results, including such benefits as validation of TM performance and cost, as well as audited, independent long-term track records of transitions providers. While such quantitative analysis represents only a portion of the total due diligence package, “it is a piece that has been missing from the industry since its inception,” says McLellan. The continued uptake of third-party analytics “will enable asset owners and their consultants to make more informed decisions when selecting their preferred transition managers.”

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ROUNDTABLE PARTICIPANTS SAL SASSANO, vice president securities lending/repo finance, Alliance Bernstein JAMES SLATER, executive vice president, global head of securities finance, BNY Mellon TIM SMITH, executive vice president, Sungard Astec Analytics JAMES TEMPLEMAN, global head of securities lending equity trading, Blackrock FRANCESCA CARNEVALE, editor, FTSE Global Markets (not pictured)

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US SECURITIES LENDING

THE STATE OF THE UNION ADDRESS: MARKETS IN FLUX

AMES TEMPLEMAN: GLOBAL HEAD OF SECURITIES LENDING EQUITY TRADING, BLACKROCK: Clearly, it has been a year where spreads have fallen; and although balances were off during the first half of 2013 they have increased during the second half of the year. Our focus has been on growing revenue, and we are also looking for opportunities to outperform. Even so, the markets are tough; this hasn’t been a great year for short selling and therefore hasn’t been a great revenue year for securities lenders generally. SAL SASSANO, VICE PRESIDENT SECURITIES LENDING/REPO FINANCE, ALLIANCE BERNSTEIN: We have seen a decline in equity loan balances and spreads this year and understandably performance is down. While performance is important, our focus tends to be more on risk and controls and the overall safety of our securities lending programs, so we devote a good deal of time to oversight of those programs. Relative to collateral management, I’ve spent a lot of time preparing for the impending regulatory changes, specifically around new margin requirements and working towards consolidating all of our processes. TIM SMITH, EXECUTIVE VICE PRESIDENT, SUNGARD ASTEC ANALYTICS: Over the last year we’ve noted that our clients have put much more focus on issues such as transparency. Clearly, and both Sal and James have touched on this, people involved in the securities lending business are looking for ways to do things more effectively and efficiently. The driver of this change is a greater thirst for understanding how securities lending fits into the greater scheme of things. Moreover, again touching on what Sal said, our current preoccupation is understanding how those risks might impact the business going forward, as well as looking at the impact of regulations that are now impinging on business. JAMES SLATER, EXECUTIVE VICE PRESIDENT, GLOBAL HEAD OF SECURITIES FINANCE, BNY MELLON: When you think about where we’re at and what we’ve been dealing with, it is really the profound change that’s going on across all of financial services that is the most striking element in today’s market. In the securities finance space, in many ways, it is even more striking. There are significant structural changes happening across the market and it is almost all regulatory driven. Business models are being challenged and value chains reorganised. We are focusing our energy on what all this change actually means for our business and clients over the long term. We are investing a lot of time and money around collateral, and how that securities finance space is evolving. Looking at it holistically, whenever there’s this amount of change, it also brings greater opportunity for those focused on it. Our eyes are fixed on what lies ahead, not back on what we can’t change.

REGULATION AND ITS IMPACT SAL SASSANO: Pending regulation has left the markets mired in uncertainty: no one is certain what the final new regulations will look like and until there is greater clarity around these issues, this uncertainty will continue. Having said that, it is clear that some regulations (depending on their final form of course) could have a significant impact on our business. Dodd Frank, Article 165 for instance, could result in material changes to indemnification provided by agent lenders. That would have a profound effect on lending with respect to program parameters, minimum spreads or changing fee splits. Depending on the outcome, some beneficial owners may even decide to pull out of their lending programs. The flipside is that change also brings opportunity: I think there will be new opportunities around collateral management. For instance asset managers that hold a lot of high quality assets may see a big increase in demand for those assets. Regulation therefore has us managing this juxtaposition of opportunities and challenges: it is an interesting time for the market. TIM SMITH: Looking at it from an historical perspective, over the last 20 to 30 years there have been a succession of regulation changes, market events and changing market conditions which have clearly impacted on the securities lending business. One of the reasons for the rise of so many associations in the securities lending segment is itself a testament to this dynamism: ISLA, RMA, and PASLA to name but three. Their main point of reference has been to look at the new regulations that are either impending, suggested, disregarded, rejected or threatened and position the industry accordingly. The story of securities lending has been about taking advantage of these opportunities. As a consequence, perhaps a positive slant should be put on the current batch of regulation, inasmuch as this business is now recognised as being a real business worthy of a formal structure rather than an ancillary product. Actually, I don’t think it is a question of people who are plying the business not wanting regulation, but instead I suggest they are really saying: yes, we do want it, but we want sensible, practical and practicable regulation. JAMES TEMPLEMAN: I don’t think there’s any suggestion that securities lending is being specifically targeted by regulators. Clearly, there’s a very broad regulatory review of financial markets, an inevitable consequence of the global financial crisis and securities lending is caught up in that process. As Tim has noted, regulators have realised that securities lending is a very important component of the global capital markets and therefore it is no bad thing if it comes to the attention of regulators and new formal regulation is the result. It is also important to say that a lot of regulation, from BlackRock’s perspective, has been welcome, such as the ESMA regulations that were put in place for UCITS funds earlier this year, which will come into full effect in 2014. In general, those rules are concerned with investor protection and we view them positively. The challenge is that there is always some detail within the regulations that don’t

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necessarily sit comfortably with day to day business. The ESMA guidelines are a good example of this. Why? Because, potentially, these rules could make tri-party collateral more difficult operationally than before. Obviously we would view this as a negative because tri-party collateral is so efficient. In this regard, there is always the risk that, even if you broadly agree with a set of regulations, there is something in the detail that results in an unintended consequence or causes a lot of (potentially) unnecessary work. The most frustrating thing for all of us is we that see a lot of contradictory regulations. I’m reasonably fresh from my transition from working in London to New York. Having been in London, and taking into account the way that the European Union operated, it was clear that, at any one time, any number of regulations were working in conflict with one another. The financial transaction tax (FTT) is probably the best example of this; in terms of the potential impact that FTTs could exert on markets, volumes and/or the EU’s growth agenda. In summary, I wouldn’t want to say regulation is a negative; often it is a good thing for the markets and a good thing for our business. I am more concerned about the unintended consequences of new market rules. JAMES SLATER: We’re certainly spending more calories and time educating beneficial owners on the impact and the implications of regulatory change. We’re also spending a lot of time (particularly over the last three years) around advocacy with the regulators around the world on behalf of our clients. We are working with and through various trade associations, actively supporting different working groups, and different initiatives to try to help coordinate. As we’ve pointed out in this discussion, the issue is often the unintended consequences of regulation. We are trying to help outline where the fine detail just doesn’t tally with the realities of the market. We find regulators are receptive because ultimately they want to make the markets safe and efficient. They encourage market activity within clear boundaries. After 2013 much more is known about what our regulatory framework will look like going forward. That said there is still a fair amount to be written and clarified.

WHAT’S NEEDED TO UPLIFT VOLUMES? TIM SMITH: Inasmuch as some of the regulation hasn’t been clarified, it has hindered activity in securities lending: but this is not a fear of regulation, it is the uncertainty that surrounds much of it that is the problem. No one wants to either put on positions or try new things if they think they’re going to have to back out of them with a loss of money down the road. However, having said that, there has been a certain limited increase in the amount of business across the board. The leverage ratio has increased and that shows that hedge funds are beginning to stick their toes more into the water and generate more demand. Even so, there is a general acceptance in the marketplace that those heady times, precrisis, were perhaps unusual and that today’s level of activity

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

Sal Sassano, vice president securities lending/repo finance, Alliance Bernstein: “You potentially have some regulations that are in conflict. It is clear that there is pressure on firms to reduce the size of their balance sheet; they’re going to have to allocate balance sheet and certain businesses may be scaled back. We’ve seen that already among institutions; banks and asset management firms, for instance. Can firms carry as much inventory of high quality assets on the balance sheet as they have in the past?”

is much more the norm. If you look at activity over time, there was a big run-up to activity in 2006-2007 period, and 2008. However, if you run the data back from 1990 through to now, that 2006-2008 actually looks more like an anomaly than anything else. In that sense, we are back to normal working. However, clearly uncertainty around regulation isn’t helping. JAMES TEMPLEMAN: I would say we have clarity on a number of different regulatory issues. However, Basel III is the big worry for most people. I am not sure anyone has clarity on what its implementation will ultimately mean for securities borrowing and lending. Much will become clear over the next six to 12 months; there’s obviously lots of informed speculation and discussion around whether the leverage ratio is going to be a significant inhibitor of business, and there are differences between Europe and the US in terms of how Basel III gets implemented, which also is going to vary on a bank to bank basis. Clearly this involves a lot of detail and nuance and for those reasons it will take time before we achieve clarity in terms of how Basel III specifically will impact the securities lending business; although from a lending perspective, it is clear indemnification will be impacted. JAMES SLATER: We’re already starting to see changes in behaviour as banks and dealers recognise that they’re going to be constrained by capital while others see that they’re going to be constrained by leverage. In turn, that is starting

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to drive behaviour. Those institutions constrained by leverage look to shrink or manage their activity on a more targeted basis with a focus on certain clients. We are also seeing trades in the market around liquidity coverage. The liquidity coverage ratio (LCR) as a concept is new, at least on the US side. Moreover, because of the regulation banks and dealers are now going out longer term on their financing activities which are affecting trading strategies. What it adds up to are significant shifts in the dynamics in and around securities finance. Securities finance is getting more attention now than it did five or ten years ago. In the past there was a term market but it was a very flat curve. Now there’s steepness to the curve and lenders that are willing to commit for longer terms are getting rewarded. That will likely only increase as the regulations further take hold. There’s a glide path between now and when these regulations come fully into place. You’ve got the supplemental leverage ratio that doesn’t fully come into place until 2018. Between now and then there is a glide path investors should expect banks to manage their balance sheets to. Things will change of course. I liken it to the developments around collateral, where there was a lot of worry about shortfalls. Some estimates say it will be in the trillions of dollars, but it is not a situation where a light switch is pulled and then the shortfall appears. There’s a glide path between now and when the full breadth and repercussions of those rules come into play. The biggest driver of course is derivatives being centrally cleared. TIM SMITH: You are absolutely right. That boils down to where everyone believes that future capital markets regulation is going to require greater use and desire for collateral; or I should say, good quality collateral which in turn will drive up demand for securities lending activity. However, the fear is that these same regulations will also make it much more difficult to actually participate in securities lending of this much needed collateral, and that’s the Catch 22—the unintended consequence that everyone fears. SAL SASSANO: Exactly.You potentially have some regulations that are in conflict. It is clear that there is pressure on firms to reduce the size of their balance sheet; they’re going to have to allocate balance sheet and certain businesses may be scaled back. We’ve seen that already among institutions; banks and asset management firms, for instance. Can firms carry as much inventory of high quality assets on the balance sheet as they have in the past? Probably not. Yet, at the same time, they’re going to be required to post more of those high quality assets to meet their collateral requirements. How will that be resolved? It will be interesting to watch how this plays out over the long term. What will it mean in terms of the new marketplace, in terms of spreads, or pricing? I believe that spreads are going to have to widen across the industry in some of these products that historically have traded thin. JAMES SLATER: For collateral providers regulatory change may actually bring wider spreads to our market. TIM SMITH: It will, in turn also lead to more buyers entering the market, from the borrowers’ side particularly

here in the States, where we are seeing this already. For example, you’ve got a lot of mid-tier brokers and smaller brokers upping their game in terms of assessing supply as much as they can. So there is definitely a change there. The business world will adapt and adopt whatever is laid before it. It always has done. SAL SASSANO: I agree, the market will find its way.

LIQUIDITY AND THE SEARCH FOR HIGH QUALITY ASSETS JAMES SLATER: Every beneficial owner has their own risk appetite and has their own objectives around lending programs; at least that’s what we find across our client base. I am reluctant to make sweeping generalised statements. Some are more willing to participate in new strategies, new trading opportunities and others less so. As a general statement, there are many central banks around the world that make their sovereign portfolios available for loan. Yet those very same asset owners (again, very generally) are very risk averse clients, and they’re typically not all that crazy about lending their stock of high quality assets and taking something of lower quality in return. Even so, there are sovereigns, state funds and others that have the experience in the market and risk capabilities and skills to judge the opportunities and leverage them. There’s no doubt that there are trading opportunities out there where you can swap high quality sovereign assets for something else, whether that be investment grade corporates or equities. Clearly there are risks that need to be considered and measured— all of which needs to fit into the institution’s risk appetite. Additionally, if it is run through a bank or a financial institution, there are capital and balance sheet implications that need to be considered. JAMES TEMPLEMAN: Jim makes a good point; we simply can’t generalise about clients. The clients that we have in our lending programme want securities lending to be a low risk activity; they are interested in incremental return on a small amount of risk. So, generally making those high quality assets that they have available to lend would be part of their normal activity. When you’re looking at specific collateral upgrade trades, it can be more challenging for beneficial owners to agree to some of the requirements of the trade. For example, collateral upgrade trades need to be for a fixed term. Normally you need to give up the right of recall; but sometimes you may need to give up the right to change collateral parameters, that kind of thing. Therefore, if we have any concerns on behalf of beneficial owners if is just to make sure that they fully understand the terms of a collateral upgrade trade before they sign on the dotted line. Additionally, then from a risk/return perspective it may well make sense for a holder of government bonds who understands their risk profile and the holding period for those bonds, to enter into a term transaction in order to increase the yield on their portfolio. We all know that yield isn’t easy to find in today’s markets and there are variations depending on the client. For some clients the risk/reward may make

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absolute sense, for others it probably isn’t the best trade, it all depends on how the underlying assets are being managed TIM SMITH: I was going to say, in terms of the characteristic, I probably look at it slightly differently from the other three gentlemen round the table, though I appreciate what they’re seeing. One general characteristic change in beneficial owner approaches to securities lending in the last few years is that they want to have more understanding and control and scrutiny of the assets that are being lent, which is actually a very good thing. Most agents too desire to have better and more informed conversations with their clients. It is actually very hard for an agent then to actually get engaged with the client who is not himself or herself engaged in the product. SAL SASSANO: At Alliance Bernstein, we want to be very engaged and are in constant communication with our agent lenders. In particular, since the crisis we’ve adopted several measures that are regarded as industry best practices. For one, we created an oversight committee that meets regularly to discuss sec lending issues. The committee includes personnel from risk, trading, compliance, tax, our portfolio management group and fund administration, which oversees all facets of our program. We also receive a daily dashboard reporting package, regular updates on regulatory developments, performance reports, benchmarking and so forth. If there is a macro event, whether it is regulatory, tax, market event etc., we get a call from our agent and work through the considerations and impact to our program immediately. Although we are confident in our agent lenders protections and oversight, we feel it is our fiduciary responsibility to our shareholders to be actively engaged and aware of the full marketplace. We want to understand our business within a wide macro and detailed micro context. I don’t know if it is the case at most beneficial owners, but I spent most of my career on the dealer side before joining Alliance Bernstein, so I brought a bit more sec lending experience than perhaps someone who doesn’t have that background. So that’s been helpful too. I’m curious as to how engaged other beneficial owners are. Are they really engaged; or, is it something that they spend only a very small piece of their day overseeing? For us, for me, it is a full-time responsibility, overseeing the securities lending and the repo trading programs. JAMES SLATER: We have beneficial owners that have dedicated staff for the product and are fairly sophisticated, if you will, and more engaged in terms of the strategies and what they’re trying to accomplish out of the program. There are several thousand beneficial owners in agency lending programmes around the world. Of that, it is only the 50 to 100 large plans that are very involved on an everyday basis, like Sal. Beneficial owners care about those macro developments that Sal mentioned. Things like the debt ceiling, they get very engaged, otherwise they fit into the category that James was describing, where they are looking for incremental income and really not wanting to take a lot of risk. So as long as those large macro dynamics haven’t changed, then they’re generally content. FRANCESCA CARNEVALE: It is always struck me as being rather strange that if I am a beneficial owner and I decide to

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

James Templeman: global head of securities lending equity trading, Blackrock: “Clearly, it has been a year where spreads have fallen; and although balances were off during the first half of 2013 they have increased during the second half of the year. Our focus has been on growing revenue, and we are also looking for opportunities to outperform. Even so, the markets are tough; this hasn’t been a great year for short selling and therefore hasn’t been a great revenue year for securities lenders generally.” Photograph © Berlinguer Ltd, December 2013.

enter securities lending as a provider of securities into the market, why I wouldn’t manage that process as deeply as I’d manage any other office activity. Given that many beneficial owners talk readily about fiduciary responsibility and are handling in some cases the money of retail investors, why should an activity such as securities lending (even if the firm has engaged a custodian or agent lender) not be something to pay a lot of attention to? I am horrified to hear some beneficial owners say they only spend ten minutes a week thinking about it. Really? I think that is unacceptable. How do they know they are really getting the best out of a programme if they don’t spend time thinking very carefully about what they are doing with the assets they hold? JAMES SLATER: We all likely have different views as to why as there are many reasons for that approach. At least one of the reasons is that a lot of organisations just don’t have the financial resources and budgets to have someone focus on securities lending for a substantial amount of time. Although logically it may make sense for them to spend incrementally another say $100,000 to hire somebody to develop and do more with the program, the reality is that if they have the opportunity to hire another person, the portfolio manager or the chief investment officer likely has something else they see as more valuable to focus on. The reality is that for most plan returns from securities lending is a few basis points. For most beneficial owners that have a diversified portfolio, it is single digit basis point returns.

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For a single asset it can be a lot of basis points, in the hundreds in some cases, but across the whole portfolio it is a relatively small portion of return. That’s one of the reasons why many beneficial owners that participate in securities lending programmes do it through a creditworthy agent bank where they get indemnification and good standards of care and protection. It means they can take a lighter touch on the program. JAMES TEMPLEMAN: That’s a really good point. If the programme is set up to run effectively from the outset, and the agent lender is doing an effective job, the beneficial owner may need to only be involved on a periodic basis to review performance. If ten minutes a week aggregates to half a day every quarter that could well be appropriate, depending on the size of the plan and the agent. A beneficial owner should be effectively reviewing the agent’s performance at the appropriate level—that is a review of returns over time, as you would for any other investment management activity against a benchmark. It would be an issue if you have an opportunity for a beneficial owner and there’s a reluctance to engage; but if we’re talking about reviewing performance of an agent lender on an ongoing basis, then I don’t think it should necessarily be a daily activity for that beneficial owner. SAL SASSANO: It is probably a little bit easier for us to be involved and be engaged every day because we trade our own fixed income repo book, so we’re already in the market. JAMES SLATER: Got to be there. SAL SASSANO: Right. For us it is clearly more than ten minutes a week, it is a lot more than ten minutes a week. Now I don’t necessarily look at rates or measure performance on a daily basis. But I will look at securities lending performance, whether it is weekly, monthly, quarterly, and take a number of different slices and we’ll compare them to our peers. We do look at counterparty exposure daily, we’re looking at margin levels daily, we are tracking fails daily and we are having conversations about regulations as new information becomes available. We want to know what’s going on in our securities lending program at all times and be ahead of any issues that might arise. However, I have to add that we also have a lot of confidence in our agent lenders and we think they do a great job in terms of performance and compliance. The markets are largely going to dictate what your returns are and our returns vary, depending on the funds. Performance is just one thing that we look at and it is not even the most important thing. About two and a half years ago we started self-managing our own collateral pool. So safety is paramount, and that’s what we spend a lot of time doing, reviewing the metrics that pertain to risk and margin and counterparty exposure and things like that. TIM SMITH: Back to your point Francesca, where you were so surprised about the time some beneficial owners think about their securities lending activities, it reminds me of that story of the frog: if you throw him in hot water he’ll leap out, boiling water, if you put him in cold water and heat it up, he’ll stay there. In securities lending historically the business was small to start with; it was used to defray other costs of

custody for institutions and wasn’t viewed to be that as important. I can remember trying to sell, doing agent lending, to portfolio managers in Hong Kong, in the late 1990s early 2000s. They basically said: why am I interested in getting another six or seven basis points when I’m just sitting and holding the stock and getting 600 basis points? So there is an historical reason why things have not been looked at so much and so that’s why you shouldn’t be too surprised when people say: oh, well we only do this for ten minutes. I think that actually now it is changing and will change further and that’s why the regulations are now being put in place for the purpose of securities lending, rather than securities lending being caught by other regulations that have nothing to do with it essentially. JAMES SLATER: Asset managers tend to have more complexity, and I’m making a real general statement here- but they tend to be more hands on and tend to more often have dedicated staff towards this product. Risk is important, and the information you need to help you achieve better management of risk. SAL SASSANO: Absolutely. JAMES SLATER: Especially in the fixed income space, it is helpful to have connectivity to the market and other views on what’s going on and what’s driving it. Portfolio managers and investment staff often find that information helpful. SAL SASSANO: Yes, we interact with our portfolio managers quite a bit. We try to provide relevant market colour and highlight other trends we see on the lending and repo side. We try to paint a picture of what’s going on in our market that is helpful to them. TIM SMITH: That’s actually a very good point. Securities lending information is becoming more and more involved with the investment management world and even the value of that information in making investment management decisions is becoming more effective. JAMES SLATER: It is true, data providers do play a much bigger role in the marketplace. TIM SMITH: I wonder whether there are differences at a regional level around the world in terms of investment management houses managing their own securities lending. I wonder whether the Dutch and the French and the Germans and the Swiss and the Swedish and the British do it more than American firms or not?

MACRO DEVELOPMENTS: HOW THEY INFLUENCE SECURITIES LENDING JAMES SLATER: Clearly, the macroeconomic environment has been one of the big stories of 2013 and leading into 2014, regulation being the other. Central bankers around the world remain almost universally concerned about inflation. With that in mind, and irrespective of US approaches to tapering, it is going to be a while before you see central bankers in general withdrawing liquidity. Quantitative easing in various sizes is likely to continue. As 2014 opens the market is probably a little bit more

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focused on the February 7th date, the next benchmark date in the debt ceiling debate and everyone will look to see how that is dealt with. The US debt ceiling continues to hang over the US market like a cloud; we were consumed with it during the fall of 2013 and we are still living with the consequences and uncertainty that it has brought in its wake. It would be great to get it done and dusted. The next thing, if we want to be more theoretically focused is what will be the consequences if tapering of quantitative easing starts to pick up momentum. Repo rates would likely start to move higher. If central banks cease being a big buyer of sovereign debt, somebody else will have to buy that debt, and rates will naturally drift higher. Even so, that debt will have to be financed and it will change the dynamic in our financing markets, ultimately pushing repo rates higher. It will be interesting to watch. JAMES TEMPLEMAN: Just looking at 2013 from a macroeconomic perspective, it was a really, really tough year to be a short seller. It has meant that there have been few special opportunities, particularly in the second half of the year which has coincided with a huge technical market rally, especially in the US. That’s meant that you have to have had a really high conviction to short any specific name. I saw a statistic recently where the number of equities that have had a negative return over the past 12 months is at a ten-year low. So the whole market is moving up and you have to have really strong conviction to be on the short side of the market I think at some point in the future when QE ends, and I agree with James, it is probably not imminent—it will be a good thing for the equity securities lending market specifically, because we’re likely to see volatility increase. Volatility’s at pretty much an all-time low at the moment, which doesn’t help with a lot of hedge fund strategies. In turn, if we see volatility increasing we’ll probably see correlations decrease—which again would be helpful for securities lending and short selling I would imagine, over time, as we see the unwinding of a central bank intervention in markets, which have partly driven the recent bull runs, you’ll see people taking on more idiosyncratic risk, more single-stock shorts, which will gradually increase the level of specials. Finally, to James’s point, I agree that we should see an increase in fixed income specials again. So, from an absolute revenue perspective, as we start to see the level of QE unwinding, that will be positive for the securities lending markets. JAMES SLATER: You have to be an optimist, that’s the only way you can stay positive in the current environment. This was a tough year for short sellers—short sellers got killed. Short interest is at multi-year lows but I sense something of a change in the markets. The last couple of weeks have been some of the best weeks of the year for IPOs. We haven’t seen as much activity as that in quite a long time. Moreover, on the corporate side, the M&A pipeline is starting to build, and there is a lot of talk around an increase in the M&A environment—that’s really what we need. In summary, we need corporate action activity to build and higher rates for securities lending earnings to improve.

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James Slater, executive vice president, global head of securities finance, BNY Mellon: “South America is an interesting part of the world. In Asia there are still markets to develop, and then there’s Eastern Europe. So there are areas of the globe with new frontiers, if you will, and new opportunities. And then further off you have to factor in countries such as China and India, but nobody knows quite how far off. Also, collateral financing remains a big theme in the market.” Photograph © Berlinguer Ltd, December 2013.

JAMES TEMPLEMAN: Yes, that’s a good point. This is an event-driven market at the moment, and thankfully there have been a number of events that have been revenue opportunities for securities lending. For example, there have been a number of companies raising capital in Europe and we have seen some increase in M&A activity; the recent airlines merger in the US being a good example. Asia has been a stand-out region in 2013 in revenue terms, despite spreads falling through the year. It is definitely not all doom and gloom and, as I said earlier, US equity balances increased during the second half of the year. It is just the level of specialness, which significantly reduced in the second half of the year. Right now hedge funds are definitely shorting, but they’re just shorting to hedge against their long exposure rather than shorting specific assets because of market conviction. SAL SASSANO: James talked about the depth of the specials market. One of the ways we look at performance is that we have our agent lenders group income into different buckets for us. We might look at ’warm’, ’hot’, and ’super-hot’. If you compare 2013 numbers with those of 2012, the majority of our income was in the highest spread bucket in 2012. In 2013 the numbers almost reversed, whereas you would think intuitively that most of your income should be in the biggest spread bucket. That wasn’t the case in 2013. There were fewer specials trading at the super-hot end of the range. Moreover, if you compare our top ten biggest earners for the year,

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comparing 2012 to 2013, every one of them in 2012 had double digit returns versus only a few in 2013. There’s simply not much depth in the specials market right now.

PRIME PERFORMANCE Versus AGENT PERFORMANCE TIM SMITH: I attended a recent conference in London and there was a dichotomy between the views presented by the agent lenders, in terms of what might be happening over the 2014, and the broker dealers, prime brokers. The brokers seemed to be more sanguine about what’s going to happen next, in terms of demand; they’re seeing more business coming through from hedge funds than from the agent lending side of things. It was very interesting. JAMES SLATER: The reasons that primes and agents are seeing things differently are that agents make money when people go short. A prime however will make money in a leverage long environment too; they do fairly well financing hedge funds that are getting long into whatever strategy they are pursuing. Anecdotally, I’ve heard more than one prime saying that they’ve had a decent year in 2013 whereas agent lenders universally are down versus the previous year. SAL SASSANO: Prime brokers primarily make money two ways: they either lend securities or they lend cash to finance longs. With the rise in the broader equity markets and growth in hedge fund assets, it’s no surprise that prime brokers have seen better returns compared to agent lenders. JAMES SLATER: It is up big and these accounts are trading, and so they just carry on. FRANCESCA CARNEVALE: It is interesting, I’ve never had such optimistic discussions with prime brokers as I have done in the last six months. Many have set up operations where they hothouse potential new hedge funds, and will seed them, help them raise investment dollars and finance and even put them in special premises; as long as they give them all the business they undertake going forward. Many of them think that this is the beginning of a new boom in the segment. TIM SMITH: That is also a corollary of the fact that they’re probably not going to be keeping their prop desks in a way. So they’re developing a prop desk by proxy, I would guess would be another way of looking at that.

THE SECURITIES LENDING OUTLOOK I: A REGIONAL OR GLOBAL BUSINESS? JAMES TEMPLEMAN: We run the business globally and always have done, and we make no distinction between clients depending on their location. We have a lending desk in Hong Kong, for instance, and they can lend the same set of client assets as the lending desk in London or in New York. As I’m sure we would all acknowledge, being global is the best way to run the business. Clearly we have to be aware of specific local regulations are and then respond accordingly, from a client perspective. There are very specific short selling

bans still in place, for example, but they are very few far in between. South Korea allowed short selling on financials for the first time for many years and so short selling regulations are definitely being lifted in various different markets or in most markets. SAL SASSANO: We operate in many global markets and work closely with our agent lenders who are a huge help in terms of walking us through the different regulations of each country. We tend to be conservative and weigh potential returns versus the risks associated with lending. And in some cases we may choose not to participate in certain markets. Equally, there are other markets we’d like to be in that we aren’t in because of the regulatory environment and also because of mutual fund specific requirements. Brazil is an attractive market with healthy returns but there are also issues which make it tricky. For instance, there are issues around collateral being held by the CBLC as opposed to our custodian. So we’ll definitely look at new opportunities but we’re always going to be conservative. And we’re going to weigh the risks versus the benefits and we’ll probably move slowly.

THE SECURITIES LENDING OUTLOOK II: NEW BUSINESS OPPORTUNITIES? TIM SMITH: It probably best for me to speak in general terms about where we’re seeing our clients seek new opportunities. There are certainly regional opportunities, with the new markets if people are looking a long way ahead, the BRIC countries in terms of opportunities there. We’re seeing that our clients are showing greater interest in looking at those new markets or trying to find ways of getting into them. Also the opportunity is there for monetising whatever assets they might have within their portfolios, or using these assets more efficiently, within the various groupings. Historically, securities lending has been a little bit in a silo; our clients are looking much more at trying to incorporate it with other activities: for instance, taking a holistic view of the greater world of collateral management or collateral optimisation. So the opportunities very real opportunities now because there’s a drive for efficiency and return once more. Moreover, because of regulation, tapering, the macroeconomic environment, we will be getting back to opportunities in the convertible arbitrage space and things like that. Also, everyone has been talking about the death of yield enhancement for about the last 20 or 30 years. That potentially will start tapering off, so new opportunities will have to be found and that’s going to be found in the area of convertible arbitrage. JAMES SLATER: South America is an interesting part of the world. In Asia there are still markets to develop, and then there’s Eastern Europe. So there are areas of the globe with new frontiers, if you will, and new opportunities. And then further off you have to factor in countries such as China and India, but nobody knows quite how far off. Collateral financing remains a big theme in the market. Also,

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capital and balance sheets are key considerations that are driving in creating opportunities in the collateral and financing space. It is apparent too that it is getting more and more challenging for primes to finance their clients, and that will create opportunities across the market. The central clearing of derivatives is also going to drive the greater need for collateral. In tandem, this activity should drive higher wider spreads and create opportunity across the market, for lenders. I’m optimistic that things are going to get better from our vantage point. For all the reasons that we have outlined, 2013 was a very tough year. Even so, it was a transition year, and we might look back at it as a useful one in which we digested a lot of the regulatory noise and responded accordingly as we gained some clarity about the future description of markets. There continues to be a lot of talk about the hedge fund sector. Certainly in 2013 a lot of groundwork was undertaken; complying with SEC reporting requirements (that sort of thing) and the good news is that much of that is now in place. In that regard, I expect to see some movement in the sector. JAMES TEMPLEMAN: We have a securities finance business model at BlackRock, where we have integrated repo, lending and financing activity. So to pick up on the opportunities coming out of regulation: as James was saying in terms of helping dealers with balance sheet management, we will focus a significant amount of time on the question: how do you make dealers more balance sheet efficient? If you can do that through changing collateral parameters, through term trading or, through trading synthetically rather than using securities lending transactions, then there’s definitely an opportunity there. SAL SASSANO: I’m also fairly optimistic looking ahead. I think that as regulatory changes are implemented, firms will innovate. Everybody’s going to have a competitive advantage in some way. Some entities may own a lot of high quality assets such as US Treasuries. Well that firm is going to have a competitive advantage in that area and it will be a good match for another counterparty who has large collateral requirements. Fed policy is another area; once the Fed starts tapering and eventually raises interest rates, some of the constraints we’ve worked under for the past several years will ease. Hedge fund assets under management are growing and we are seeing new funds launch. Strong growth in hedge fund assets will see more money put to work on the short side of the market and so overall I’m pretty optimistic.

LESSONS OF THE FINANCIAL CRISIS: THE WAY AHEAD? JAMES SLATER: It’s a tough question. I should preface any answer by saying none of us want to go through another crisis, especially beneficial owners which had a very rough time. For me personally it certainly was challenging but intellectually it was very interesting and in a lot of ways (I was in Canada at the time) it was a time to learn. I’d spent most of my career planning a similar situation like 2007, where

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Tim Smith, executive vice president, Sungard Astec Analytics: “I attended a recent conference in London and there was a dichotomy between the views presented by the agent lenders, in terms of what might be happening over the 2014, and the broker dealers, prime brokers. The brokers seemed to be more sanguine about what’s going to happen next, in terms of demand; they’re seeing more business coming through from hedge funds than from the agent lending side of things. It was very interesting.” Photograph © Berlinguer Ltd, December 2013.

you’d have a major default. And while there were issues around reinvestment through the financial crisis, the core securities lending business held up remarkably well. I would go so far as to say that the industry itself handled the crisis remarkably well. I was certainly proud to be involved and part of all of that. There are important lessons from the financial crisis. It helped ground people and that was an important development. Tim talked about 2006-2008 being an anomaly; we saw oversized returns, which were in some ways aligned with oversized risks. There’s no such thing as a free lunch; everything’s about risk and return. If you’re generating oversized returns you just might have oversized risks. Hopefully that doesn’t get lost on the market again, and people are more grounded on intrinsic lending, participating in lending to extract intrinsic value and not to use securities lending as a tool to leverage their fund. JAMES TEMPLEMAN: As James says, the industry did hold up remarkably well if you look at the way that the legal infrastructure and the borrower default process worked under stress the industry held up pretty well . I was previously Chairman of ISLA and saw at first hand the difficulty of making policymakers understand the real benefits of securities lending and in part this was because we didn’t have good data. I do not believe that regulators have enough transparency into the securities lending business, so one of the develop-

US SECURITIES LENDING

ments I hope to see is increased transparency, and that’s partly because I do not think that securities lending contributes to the overall level of systemic risk in the market and the data should prove this. One of my frustrations in the post crisis period is that it has been challenging to demonstrate this very point to regulators. In a related development, I believe strongly that the industry should welcome the work that the Financial Stability Board (FSB) is doing now to increase market transparency. One reason they’re looking at, for example, mandating haircuts for securities finance is that they did not have the level of transparency they needed over what happened during the recent financial crisis, in terms of haircuts and securities finance activity. They are picking up on one very small part of the repo market for securitised debt, where haircuts did significantly increase and are then applying that analysis across the whole of securities finance as a potential solution. Actually, I don’t think this is necessary; though I totally understand why it has come about; precisely because we don’t have the level of transparency that the market requires. TIM SMITH: Just to add to that, there is a general challenge to your basic premise, that there was an issue with securities lending. Securities lending is the mountain, there was an avalanche on that mountain but the mountain still stayed where it should be and performed correctly. JAMES TEMPLEMAN: That’s definitely better than the frog analogy! TIM SMITH: Absolutely! However, the benefit that has come out of this is that securities lending has come out of the shadows. Securities lending has been a back room facilitating activity that was generally kept out of the public domain because it wasn’t necessary to be there. So one of the benefits is that the spotlight has been thrown upon securities lending and it has not been found wanting. That speaks to be basic premise that securities lending is now a proper business that should be regulated in a proper way, not just caught by unintentional regulations and rules. Now that it is actually come out into the open it is a much better place for it. That’s a definite plus for the future. SAL SASSANO: Since the crisis, especially speaking from a beneficial owner’s point of view, there has been a paradigm shift with respect to how firms manage their collateral pools. For starters, beneficial owners want to know what assets are held in that collateral pool, and what the portfolio manager’s overall philosophy is towards reinvestment. There are more internal discussions about the merits and risks of cash versus non-cash collateral. Before the crisis, the“Intrinsic Value”philosophy was far less common. Now it is a big part of what beneficial owners are focused on and is considered by many to be an industry best practice. Changes such as these look now to be permanent and are a result of the lessons learned from the financial crisis. Beneficial owners understand that securities lending is a piece of their overall investment strategy and that they need to manage the risks commensurate with the expected returns. All these factors have contributed to a significant shift in behaviour.

WHAT SHOULD BENEFICIAL OWNERS LOOK OUT FOR IN 2014? JAMES TEMPLEMAN: I really hope that 2014 is the year where we see the end of global macro events and crises driving economies. I would prefer that we don’t have another euro sovereign debt crisis and there is a smooth exit from QE and other central bank unconventional policies, which would allow markets to be influenced by company specific fundamentals and become a much better environment for short selling. That would be good for both the broader market and for our business specifically. Clearly though, there is a risk of short term market volatility, so beneficial owners need to be very focused on interest rates so that they can adjust cash reinvestment portfolios ahead of interest rate increases. That a very important trend to watch out for. Additionally, beneficial owners still need to watch regulation very carefully as I see a number of regulations in play where there isn’t enough clarity about the consequences of the new rules. Interpretation one way or another could have a negative impact on business. I’ll give you an example. It is still not clear whether, under ESMA guidelines, what only accepting high quality assets as collateral will actually mean in practice. There is a risk that high quality assets are defined as not including equities, which for European UCITS funds would be a very significant change. That’s just one example of how you have to be watchful of specific regulations where a definition or a particular phrase might seem quite benign at first glance, but which can actually have a fairly big impact on beneficial owners. SAL SASSANO: With respect to the regulations we have to see how this all plays out. But as banks await new capital calculations, what becomes of indemnification is something that’s pretty important to beneficial owners, mutual fund boards, insurance companies, pension funds, and the like. I’m curious to see where that goes. I’m not sure anybody really knows yet whether indemnification goes away entirely or whether beneficial owners have to pay up for it, or if there’s no change at all. However, this is clearly a key area of focus and in our business it is one of the biggest issues that will be impacted by regulation. TIM SMITH: The two things would be A and E; A for being alert, in terms of what’s going on and what are the changes that are going on. A is also about being adaptable, to be able to change one’s program to match changing market conditions. The E’s would be to manage your expectations to be realistic in terms of what can be achieved and not always look back to what has been achieved in the past. Also E is also to be efficient and effective in terms of running that program in a way that minimizes costs because costs are far and away for our clients, the biggest thing that they’re trying to control. JAMES SLATER: I am optimistic about the future; you have to be. There’s been a lot of change this last year and I think 2014 will be about getting on with the change. To be successful, you have to adapt and you need to continuously reassess your strategies. There’s still a lot to be written on where we’ll settle over the coming years, but this year is about knuckling down and getting on with things. I

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MIFID

The first iteration of the Markets in Financial Instruments Directive (MiFID) was a game changer: the seeming monopoly of Europe’s national stock exchanges was broken for ever. European politicians reached agreement on MiFID II on January 15th this year, and while the industry is glad of the greater certainty, many have grave concerns over some parts of the revision to the first iteration of the directive. Will it be the game changer that the first iteration was? Will it add benefit to the trading market? Some say yes, others are less sure. In fact many market commentators are already talking about MiFID III. Ruth Hughes Liley reports. Photograph © Ronfromyork/Dreamstime.com, supplied February 2014.

MiFID II: the search for the right level of transparency HE MOST CONTROVERSIAL point is a cap on dark trading at 4% of a stock’s volume on an individual venue and 8% across Europe, proposed by legislators as a solution to equity market transparency. With an estimated 98% of buy side traders, according to TABB Group, opting to interact with dark order flow, and 90% of European institutional traders having serious concerns about a cap, it has become a hot topic. “Equities are suffering from overtransparency,” believes Andrew Bowley, head of business operations and risk at Instinet.“You don’t want transparency if you have a large block to trade but the new rules limit how much can be traded in the dark.” Arjun Singh-Muchelle of the Investment Managers’Association, says the decision was very much political and shows a complete misunderstanding of how markets work. He sees a future where exchanges could refuse to handle or complete trades. “If trade in a stock is reaching 3.8%, a venue will stop trading in that stock because it doesn’t want to be that venue which is shut down from trading that stock. Yet big institutional investors could fill the 4% in one trade.”

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Adam Eades, chief legal and regulatory officer, Bats Chi-X Europe, which has two dark order books, says: “There appears to be no substantive evidence for the basis of the cap levels. Originally the proposal was for 5% and 10% before further political pressure reduced them to 4% and 8%. We are stuck with a proposal which looks unfit for purpose and there are a number of technical issues: how do you suspend trading in a given security as the cap is reached? It’s a potential minefield to police this. The venue cap seems to be penalising the most efficient and costeffective venues and forcing people to go to the less attractive venues.” At the moment, dark trading is permitted subject to several waivers: that the trade takes its price from a ‘reference price’, usually the primary exchange; that the trade is ‘large-inscale’; or that it is a negotiated trade. Under the new legislation, the dark trading cap applies to the reference and negotiated trade waivers. Bowley points out:“There is a concern that the negotiated trades and reference price waivers might be added together.

MIFID

The reference price waiver could probably fit into the 8% cap and Rosenblatt has estimated that it makes up about 11% of European flow. But the negotiated price waiver is capturing all kinds of off-exchange trades and with current duplicative reporting obligations, over-the-counter trading makes up 40% of European trading.” Drew Miyawaki, senior trader, global equities, Legal and General says:“Although the cap is getting the majority of the focus an overlooked point is how accurate consolidated volume data will be captured and measured so that enforcement of the rule can be implemented.” At Liquidnet, Per Loven, head of EMEA Corporate Strategy and Product, agrees:“Everyone in the entire industry is wondering how this is going to be measured in practice. What is the real volume out there? What happens if a broker does internal trades and inflates volume? How do you make sure you measure the correct picture of real trades one can interact with, rather than administrative trades?” Many think the consolidated tape of post-trade data to be established under MiFID II would be an accurate measure, but this will not happen immediately as regulators are waiting to see whether a commercial solution for the tape emerges. Graham Dick, now head of sales at Aquis Exchange, asks: “But how can a dark cap be monitored without a tape? Implementation of a post-trade tape is absolutely essential.” Dick was at the forefront of a voluntary initiative called the COBA project, to set up such a tape in 2013. He says lack of clarity over the outcome of MiFID II caused the team to suspend the project. “It was unclear whether there would be a single tape provider or multiple providers. Now MiFID II has been published there is still no definition as to how they are going to proceed. The work COBA was doing proposed a commercial solution and it will need a commercial solution to work. It’s a shame for the industry because it will take another two years before we roll this out if we are lucky,” he adds. One of the stipulations is that data must be available on a ‘reasonable commercial basis’. Eades does not believe a commercial solution will emerge early.“The exchanges [that] own the data have no incentive to cut prices, because data is such a significant revenue stream for them. We think it will have to be mandated by regulators so a solution could take many years.” BATS Chi-X Europe is positioned to become the main pan-European post-trade reporting venue as Markit closes its BOAT OTC reporting service in September this year. BATS’ service, BXTR, was launched in October 2013 and took around 40% of the market in its first month, according to Eades. It’s a different picture in the clearing space, where exchanges which direct trades for clearing to their own clearing platforms—vertical silos—will potentially have five years before they have to allow open access for derivatives clearing. This will make it very hard for new entrants into the derivatives space, according to Eades. “Because of the time delay allowed for even the larger clearing houses, it is going to be difficult for trading venues like us to compete with the big boys.”

Adam Eades, chief legal and regulatory officer, BATS Chi-X Europe, which has two dark order books, says: “There appears to be no substantive evidence for the basis of the cap levels. Originally the proposal was for 5% and 10% before further political pressure reduced them to 4% and 8%.

Mark Goodman, head of electronic services, Société Générale, believes the market-wide cap could have a big impact on small cap stocks and even sees a chance it could affect the European economy.“Where I worry is if you have a small cap with very little activity, and suddenly see 20% of the volume traded and the cap kicks in, activity will not move to the lit market and I think people will stop trading. As a result will investors shy away from including these small caps in their portfolios? Considering the importance placed on support for small and medium enterprises in Europe as a driver for economic growth this seems counterproductive. The aim should be efficient markets, not transparency as an end.” Singh-Muchelle agrees: “The corporate bond market in Europe is relatively illiquid apart from new issuance so a volume cap on top of an already illiquid market will sap up liquidity even further. Trading data will become even more valuable. We need to know where the last trade was done, and the last volume and now we also need to think about percentage traded.” MiFID II introduces new Organised Trading Facilities (OTFs) for non-equity trading, aiming to ensure that “trading, wherever appropriate, takes place on regulated platforms”. For equities, some point out that with no OTF system currently, it won’t make much difference. Internal broker matching systems will have to be authorised. As to where this flow will move, the large exchanges hope to see it return to the lit, primary markets. Indeed, according to LiquidMetrix latest figures, primary venues have been gaining market share on most indices for the last four months. Other flow may head towards whatever develops in place of broker crossing networks.

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“Equities are suffering from over-transparency,” believes Andrew Bowley, head of business operations and risk at Instinet. “You don’t want transparency if you have a large block to trade but the new rules limit how much can be traded in the dark.”

At Liquidnet, Per Loven, head of EMEA Corporate Strategy and Product, agrees: “Everyone in the entire industry is wondering how this is going to be measured in practice. What is the real volume out there? What happens if a broker does internal trades and inflates volume?

Currently 13 crossing networks are listed as Systematic Internalisers (SIs) on the ESMA database, but many of these are fixed income. This compares with 156 MTFs, 100 regulated markets and 20 central counterparties. Some believe some firms will choose to re-register equity platforms as SIs, which use real-time quotes. Many of the larger broker dealer have set up MTFs alongside their internal crossing networks. UBS, for example has UBS MTF alongside UBS PIN, which was an SI before it became a BCN, while Goldman Sachs has its MTF SIGMA sitting next to SIGMA X, its internal crossing network. Bosses at Credit Suisse are still deciding where to place Crossfinder, its broker crossing network. Société Générale’s dark pool, Alpha Y is currently run as a BCN using the price reference waiver, and the team have been discussing their options. Mark Goodman, believes the changes could lead to more fragmentation.“Under MiFID II, it looks like one system will be replaced by two. We stayed as a BCN because clients like the fact that we have discretion so can decide who accesses the pool and they wanted to be able to interact with the principal equity flow that we are hedging our derivatives with. “In an MTF structure, you don’t have the concept of discretion and can’t have principal or prop flow, so we won’t be able to cross this flow with client flow unless we also set up a systematic internaliser; so one BCN is replaced by two venues. Some firms generate principal flow through portfolio risk activity; if they can no longer internalise 40% of the flow will the subsequent increase in cost mean you have to price less aggressively?” Loven believes more trade will be done under the largein-scale waiver, which Liquidnet uses for most of its trades:

“If the 8% cap in an instrument is triggered, no-one would be able to trade that name in the dark unless under large-insize waiver. The buy-side would have to trade in a lit environment and suffer higher implementation and transaction costs unless trading in large blocks. This will affect insurance schemes, pensions, savings and will cost us all money. It’s at the expense of the end investor.” Wherever trades ends up, costs for the buy side will grow, as Singh-Muchelle points out: “Traders will have increased data costs because they will have to look at other venues to see where to trade and will have to pay for the pricing data.” On the other hand, Drew Miyawaki says: “Explicit costs have been falling for a number of years and there will continue to be pricing pressure on explicit costs. Fluctuations to implicit costs will also need to be examined closely. The burden to keep up with technology costs of trading today is budgeted for in larger firms, but it's more difficult for a smaller asset management firm to afford. In a firm like Legal and General Investment Management, we benefit from substantial internal liquidity. Larger asset managers will continue to capitalise on this economy of scale.” Most seem to agree that the MiFID II proposals for algorithmic trading are sensible. Andrew Bowley says: “ESMA will now have to give some guidance to national regulators as to how far they need to investigate algorithms because national regulators are nervous about looking at codes and algorithms.” Goodman says: “Early on in the discussion it was about how to manage HFT by imposing minimum resting times. However the BAFIN, [the German regulator] has mandated

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MIFID

Arjun Singh-Muchelle of the Investment Managers’ Association, says the decision was very much political and shows a complete misunderstanding of how markets work. He sees a future where exchanges could refuse to handle or complete trades.

Mark Goodman, head of electronic services, Societe Generale, believes the market-wide cap could have a big impact on small cap stocks and even sees a chance it could affect the European economy.

a way for a regulator to identify the algorithm that generates an order, so there is a better order trail and regulators will be able to ask more informed questions of brokers or high frequency traders. If you get that transparency and it is better understood, then a lot of the suspicion and concerns go away.” Eades points out it is still unclear as to what ‘direct electronic access’ includes.“Now you can go directly through your broker or through sponsored access arrangements. We are fully supportive of not having naked access—we just need to understand how the definition plays out in the Level 2 discussions.” Regarding best execution, Goodman says ESMA will also define certain venues as a minimum which brokers will have to have access to when they are executing orders. “We think this is a good thing as it will mean that quality rises to the top. It is not so open to interpretation. However, it will impact people who will have to spend money on technology to connect to certain venues or will have to start to use another broker. Interestingly ETFs will also be included, so we will probably see more on exchange activity in the European ETF market, but also the same challenges we will see with equities.” How ready firms are for MiFID II, expected to be implemented at the end of 2016, is open to debate. Loven says: “You can’t really initiate technology projects if you don’t know exactly what the landscape is going to look like and how to adhere to detailed rules. I think there is leadtime; we are around two years away from firms having to be fully ready.” The European Parliament will formally sign off the legislation by April this year, at which point the European Secu-

rities Markets Authority (ESMA), will begin spelling out the technical details of the directive. However, ESMA still classes itself as a start-up agency in 2014, according to its 2014 budget plan. It is expecting to take on 35 more staff plus national experts, taking its numbers to 185 full-time equivalent employees, but even so it has dropped some work from its original 2014 plan. It has allocated 18 people and a budget of €3.3m to draw up the technical standards for MiFID II and MAD, the Market Abuse Directive, and is aiming to complete by Q4 2014. Loven believes that they have the power to enact rules, but is not sure they have the resources and detailed specific competence: “[Those figures are] far from sufficient in my mind. Having said that, they don’t have to do all the work themselves; they can use the national regulatory bodies and advisory industry experts as well.” Indeed, ESMA has appointed three consultancy firms to help with its assessments on the impact of MiFID on the financial industry. The Centre for European Policy Studies will work alongside Insead OEE Data Services and TABB Group. Andrew Bowley says that these impact assessments will be vital.“If ESMA do an impact assessment and find they need to change the dark trading cap, for example, they might be able to change it, but this is not certain. Impact assessments are key.” As discussions are expected to continue for some time, Miyawaki concludes:“There is a lot of energy being spent on this currently. The official text is not yet finalised and it won't be implemented until late 2016 as an initial expectation. There is plenty of time to adapt and prepare for this regulation and directive.” I

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THOUGHT LEADERSHIP ROUNDTABLE

SECTION NAME

TRADING TECHNOLOGIES: DEFINING TOMORROW’S WORLD

Delegates: Serge Alexandre, sales director, Otkritie Securities; Danil Baburin, manager, product development, Arqa Technologies; Andrew Bailey, product and sales manager—exchange hosting and proximity services at London Stock Exchange Group; Tim Bevan, head of international services, prime brokerage, BCS; Jim Kaye, product manager, electronic trading, Bank Of America Merrill Lynch; Vladimir Kurlyandchik, business development director, Arqa Technologies: Peter Rowe, head of electronic trading, Renaissance Capital; Francesca Carnevale, editor, FTSE Global Markets.